Flexible spending accounts (FSA) permitted under Section 125 of the Internal Revenue Code have been around for a number of years. Employers large and small offer this option to their employees, but for the most part the medical FSA is underused and undervalued.
Now is the time to change the perception and structure of the health care FSA. With Congress in a tax-cutting mindset, modest changes in the FSA will enhance its value to both employers and employees and will assist in solving several long-term health care issues for the United States.
The vast majority of employers who typically remain silent on legislative issues must not let this opportunity go by. This is the first in a series of articles addressing the medical FSA and how employers can influence Congress to make the FSA an integral part of health care cost containment strategies and national health care policy.
Birth of a notion
The popularity of the FSA as a tax-efficient way to pay for unreimbursed health care expenses diminished somewhat with the growth of managed care plans and the accompanying decrease in employee out-of-pocket potential liability.
FSAs came on the benefits scene when the traditional health plan with deductible and 80% coinsurance was the most common plan design. That is no longer the case. Today, the out-of-pocket liability is typically an office visit co-payment. But increasing health care costs, anti-managed care sentiment and demands for freedom of choice mean higher employee out of pocket costs.
Perhaps we view the FSA much too narrowly. There are a number of major health care issues facing employers and the nation. Viewing the medical FSA as a strategic tool may help us deal with the following issues:
- Managed care is rapidly losing its ability to control health care. Costs are increasing, and fewer restrictions on obtaining health care will lead to higher patient out of pocket costs because out of necessity, co-payments and coinsurance will rise.
- Employer-paid health benefits in retirement are rapidly disappearing, and those fortunate enough to have such coverage will pay a greater portion of the cost.
- High costs for prescription drugs, increasing employee cost-sharing and the larger issue of coverage for prescriptions among the retired population are key concerns for employers.
- Employers seek ways to define the future cost of employee benefits as opposed to offering plans with open-ended liability, typically increasing at rates higher than general inflation.
- As new health care services such as laser eye surgery and lifestyle drugs are introduced, pressure will mount for coverage of these items.
Allowing annual rollover medical FSAs for active employees and workers moving into retirement will help address all of these issues. Removing FSAs from health plan status for COBRA will encourage employer support. In addition, removing the use-it-or-lose-it provision will discourage unnecessary health care spending simply to avoid forfeiting one’s account.
The ability to transfer unused FSA funds into a medical IRA will assist individuals between jobs, while allowing FSA funds to be transferred from one employer to another will provide consistency in benefits. Greater flexibility with FSA money will allow greater flexibility in obtaining medical care consistent with the popular idea that there should be fewer restrictions on where, and from whom, an individual is allowed to receive treatment.
Relying more on pre-tax dollars placed in an FSA can heighten the awareness of health care costs and make consumers more cost-conscious.
An analogy may be drawn between the FSA and direct reimbursement dental plans. Granted, people are generally more objective when making dental care decisions, but giving people a pool of money and allowing them to spend it as they see fit without the provider involved in filing claims or any other paperwork has its place in certain health care encounters.
In fact, for non-catastrophic care, the provider need not be involved other than to obtain payment from the patient. The patient spends a limited pool of money as prudently as possible. Difficult? Definitely, but not impossible for many subacute health care services.
Regs diminish effectiveness
The government provides and the government taketh away. The tax advantages of the FSA were simply too much for regulators to accept so the use it or lose it doctrine was adopted. Apparently 401(k)-type restrictions on the use of pre-tax money are not sufficient to limit perceived abuse within Section 125 of the code, so additional risk is required.
In their convoluted wisdom, regulators decided that the medical FSA was a health plan for the purpose of COBRA. More administrative burdens for employers and more confusion for participants have resulted.
Why would anyone want to place after-tax dollars into a medical FSA under COBRA and pay a 2% additional “premium” only to receive one’s own money in return? From the employer’s perspective, a participant can elect to place a large amount of money into a COBRA FSA the year after termination of employment, collect the full amount of the selected benefit in the first month or two of the year and simply stop making premium payments thereafter.
The COBRA connection is consistent with the premise that medical FSAs should operate like health plans. That is, the employee’s pre-tax contribution is the “premium” and the selected annual contribution is the benefit. And like traditional health insurance, there is no relationship between the monthly premium and the maximum benefits.
This allows an employee to select $5,000 in the FSA, collect reimbursement early in the year, and if employment is ended, leave the employer on the hook for the uncollected funds. Part of this logic appears to be that given the pre-tax nature of the contribution, it is technically employer money.
This misguided logic, coupled with the COBRA connection of the FSA, causes many employers to limit their risk by capping the maximum contribution to a medical FSA. The once traditional $5,000 is now $2,000 or $3,000. For employers who stayed with the $5,000 range, the risk has been minimal.
Why all the complexity over the FSA? Why is it necessary to take a simple concept and codify it to the point of penalizing employers and employees alike while inhibiting the value it can provide?
Clearly if one is going to enjoy a taxfavored status, some restrictions on the use of that money are needed. Place money in an IRA and there is a penalty for early withdrawal. Contribute to a 401(k) and there are restrictions on early withdrawals coupled with additional taxes. That’s fair enough. But if you place money in a medical FSA and guess wrong during a twelve-month period, you lose it.
I once had an employee visit her dentist in December and was told she would need extensive periodontal work the next year. Since these benefits were limited under the dental plan, she placed $5,000 in her FSA. Upon returning to her dentist in January of the following year she was told his assessment of her problem had changed and the work was not needed. This tax evader lost her $5,000 less what she could generate in “benefits” by purchasing new glasses she really didn’t need and by having a routine physical with all the bells and whistles.
Use remains modest
While the use-it-or-lose-it provision can be managed to a certain extent, it nevertheless inhibits effective use of the FSA. Describe the FSA concept to an employee and all goes well — until you get to the point of explaining whatever is left at the end of the year is forfeited.
You mean I lose my money? Who gets my money? Well, uh it’s used to pay administrative expenses, the employer keeps it or it’s donated to charity. Enlightened employers reallocate the forfeitures among all FSA participants in the following year. So, if you were like our periodontal friend, you really didn’t lose the entire $5,000; after reallocation you received $12.32 cents back and so did all your fellow workers with FSAs.
What if I place $1,000 in my FSA and can only use $750 in the year, I lost $250 right? Well, not exactly. Chances are that if you did not place the $1,000 in the FSA you would have paid the $250 to the federal government in the form of income and Social Security taxes anyway. Logical as that is, the average worker wants no part of it.
According to research done by the Heritage Foundation in 1998 and based in part by surveys prepared by Hewitt Associates, employee participation in the medical FSA runs about 20%, and the average annual amount allocated to an FSA is between $700 and $800. Most employers find participation in medical FSAs remains steady over the years.
At Schering-Plough, Vincent Sweeney, manager, employee benefits, reports above-average participation of 34% in 1999, 35% in 2000 and 33% in 2001.
Another employer speaking on background recently commented that “to some extent [FSAs] have become a necessary evil. I don’t think the Health Care accounts are used effectively. Most people who participate err on the low side to avoid forfeiture but most employees don’t bother with them at all. I think the ability to roll some amount forward to the following year would improve participation rates and better justify the relatively high admin fees we pay for FSA. Our enrollment is approximately 12%, and percentages have remained fairly constant over the years.”
Gary B. Kushner, president of Kalamazoo, Mich.-based Kushner & Company, no longer believes many employees are frightened by the 1984 use-it-or-lose-it rule, nor employers by the 1989 “risk shift rule.”
“Both IRS attempts at killing off FSAs were spectacularly less than effective,” he says. Kushner notes that the actual level of forfeitures under medical FSAs is miniscule, averaging $17.43 per year per participant among his own clients, and is more than offset by the tax savings.
This view appears to be in the minority, however. More benefit professionals blame the forfeiture rules for participation rates at or below 20% and also for flat participation growth over the years. Even employers who have heavily promoted FSAs and have both seeded accounts with company money and designed benefit plans with use of the FSA as an integral part of the plan find little success in maximizing the use of FSAs.
Future articles on the medical FSA will address innovative ways employers are using the plans. We will also discuss the key players in Congress and the possibility for changes in the law. The timing is right to change the scope of the FSA and to enhance its value, but little will happen unless members of Congress understand the issues and the value that rollover FSAs can bring.
In 1998 the Heritage Foundation estimated that the annual revenue loss from allowing year to year FSA rollovers was only $482 million. Hardly a rounding point in terms of the surplus and the value that could be derived if the FSA became a strategic element in cost-sharing, cost awareness and health and prescription coverage for future retired workers.
Sitting back and waiting for the next round of regulations won’t cut it. Nothing will happen if employers do not take up the challenge.