With the Cadillac tax hurricane still scheduled to come ashore Jan. 1, 2020, Congress considering capping Section 125 benefits, and the continued rising cost of group health plans, employers have more reason than ever to encourage employee migration out of higher-priced plans into more modern designs. Last month, we discussed how a defined contribution approach eliminates the employer subsidy of these higher priced plans and encourages this migration.
However, employers utilizing a defined contribution approach often still see sizable enrollment remaining in the higher-priced plans, even though these plans are often not in the employee’s best financial interest. Why do employees choose to remain in these plans? I’ve always chalked it up to inertia, lack of understanding and the prestige factor of being in the highest priced plan. What I didn’t know until last week is that behavioral economists have a better explanation: the endowment effect.
Have you read “The Undoing Project” by Michael Lewis? This biography of Israeli psychologists Daniel Kahneman and Amos Tversky overflows with fascinating insights into our individual decision-making processes. The number and depth of these insights intellectually overwhelmed me. As a managerial economics major, reading the arguments presented was like taking a flurry of body blows from Sugar Ray Leonard. Their insights fractured my very foundation of microeconomic understanding.
Specific to why employees remain in the higher-priced health plans, let’s consider The Undoing Project’s presentation of Nobel Prize winner Richard Thaler’s endowment effect:
People attached some strange extra value to whatever they happened to own, simply because they owned it, and so proved surprisingly reluctant to part with their possessions, or endowments, even when trading them made economic sense.
The endowment effect, for example, explains this scenario: Your friend buys a new kitchen table and promptly places his old table in off-site storage for $75 a month in storage fees. You then ask him, “If you never owned that old table and came across it at a yard sale, would you consider buying it and putting it in storage for $75 a month?”
Your friend exclaims, “Are you kidding? No way!”
Here’s another example: I have a client that previously offered one health plan option. It was a traditional 100/70 PPO with no in-network deductible. Years ago, we introduced an additional modern plan option. Out of courtesy, the employer felt compelled to continue offering the 100/70 PPO plan, using a defined contribution approach, even though it was all but impossible for an employee to spend less via aggregate premium contributions and out-of-pocket expenses in the 100/70 PPO than in the newly offered plan. In short, for individuals staying in network, enrolling in the 100/70 PPO was similar to spending $750 to insure a $500 risk. There was no way to win the bet.
While I argued that this 100/70 plan should simply be terminated, the employer figured that employees would understand the math and migrate out of the plan, meaning the plan would fade away on its own. That was 7 years ago. There is still more enrollment in the 100/70 plan than in the modern plan. While this employer’s defined contribution approach shields the employer from paying for the cost of the 100/70 plan, it’s possible that this plan will lead to Cadillac tax liabilities and/or Section 125 cap taxations, depending on the action or inaction Congress takes in the coming year or two.
How can we use the endowment effect to turn this choice on its head? One idea is to cease describing to employees how much they could save by changing plans. Instead, we could ask the employees to imagine that they are already enrolled in the lower priced, modern plan. Then, we would ask them if they would ever considering paying more in premium than the underlying risk to buy-up to the 100/70 plan.
The idea is to break the endowment effect by changing the perspective. We change the perspective by changing the story: “People [do] not choose between things. They chose between descriptions of things,” according to Lewis.
Our new story would also factor in our tendency to bend probabilities. Per Kahneman and Tversky, we tend to convert the true mathematical probability into a much different probability in our mind by applying emotion. For example, while the mathematical probability might actually be one in a billion, the emotion in our mind converts it into just one in ten thousand.
This insight might explain why employees tend to overpay for the ability to go out of network, even when the probability of ever getting through the out-of-network deductible is remote.
For example, on a plan with an out-of-network single deductible of $4,000, if the individual does not incur more than $4,000 in expenses out of network, the plan financially operates as if there is no out-of-network benefit. And, short of incurring a major elective claim out of network, it’s extremely difficult to amass $4,000 in expenses. Nonetheless, when I make the argument to employees that it doesn’t make financial sense to pay for out-of-network coverage featuring a $4,000 deductible to insure $500 in probable dermatologist visits, I often lose the argument. “The Undoing Project” reveals that I’m undervaluing the probability in the employee’s mind of spending more than $4,000 in out-of-network expenses.
We need to change our description of things. We need to change the story.
Epilogue: Surprisingly, Kahneman’s and Tversky’s insights were published decades ago, long before I studied the history of economic thought. Figuring I’d just forgotten the chapter on Kahneman & Tversky, I just picked up my old textbook and thumbed through the index. My memory didn’t fail me — they aren’t mentioned. Fascinatingly, these two weren’t even on Lewis’ radar screen until 2003.
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