Cafeteria Plan—Flexible Benefits

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Cafeteria PlanFlexible Benefits

A cafeteria plan, also called a flexible benefit plan, allows employees to choose from a menu of optional benefits the ones that best fit their individual needs. Cafeteria plans earn their nickname from the flexibility they give employees in customizing their benefits from this menu. In a cafeteria plan, benefits required by law (e.g., Social Security, unemployment compensation, workers' compensation) and those mandated by company policies or labor agreements are supplemented by a list of other benefits to which employees can subscribe.

Employees' choices of optional benefits are limited only by the total benefit dollars available and the variety of benefits offered by the employer. Optional benefits that are often part of cafeteria plans include dental insurance, vision care, group-term life insurance, child care, and disability insurance. Many companies offer some form of cafeteria benefit plan to their employees, although smaller companies are less likely than larger companies to offer flexible benefits.

Most cafeteria plans are compliant with Section 125 of the Internal Revenue Code. This means that they meet specific requirements set out by the Internal Revenue Service (IRS). Such plans offer the potential of cost savings both to employers and employees, particularly because amounts spent by either the employer or the employee are spent out of pre-tax earnings. Thus, both employers and employees may save on Federal Insurance Contributions Act payroll taxes. The employee also may save on state and federal income taxes.


Employers offer several variations of cafeteria plans, including core-plus plans and modular plans. Core-plus plans provide a set of mandatory benefits that are usually designed to meet the basic needs of all employees. In addition to legally-required benefits, medical insurance, long-term disability insurance, and retirement benefits are often included in the core. Optional benefits are offered to employees who spend benefit credits to select other benefits that best fit their needs.

Modular plans usually package several different bundles of benefits that offer increasingly extensive arrays of benefits. The basic module might include only the legally-required benefits, basic health insurance, and life insurance. A second module might include everything in the basic module plus additional benefits. A third module might include everything in modules one and two, and additional benefits. Employees would choose the module that best fits their needs and life situation.

Two specific benefits are often part of the cafeteria plan: pre-tax health insurance premium deductions, known as a Premium Only Plan (POP), and flexible spending accounts (FSAs) for dependent care and out-of-pocket unreimbursed medical expenses. Under POP plans, employees may elect to withhold a portion of their pre-tax salary to pay for their premium contribution for most employer-sponsored health and welfare benefit plans. The POP plan is the simplest type of Section 125 plan. It requires little maintenance after it is set up through a company's payroll.

FSAs are reimbursement accounts that employees fund based on those qualified expenses that they expect

to incur during the year. As mentioned previously, the two main types of reimbursement accounts are dependent care and health care reimbursement accounts. While there are no federal limits on how much employees may set aside, there are employer-mandated limits. Employers set an annual maximum on FSAs, which are subject to an annual use-or-lose rule. An FSA cannot provide a cumulative benefit to the employee beyond the plan year.


Perhaps the largest problem with cafeteria plans, as opposed to one-size-fits-all benefit plans, is that cafeteria plans are more complicated to administer. Since employees choose individualized benefit packages, the company must take care to record and maintain each employee's benefit package accurately. The company must maintain adequate communication with employees about changes in the cost of benefits, their coverage, and their use of benefits. Employees must also be offered the opportunity to revisit their benefit choices and make new selections as their needs and life situations change. Additionally, employers must comply with IRS rules and regulations regarding cafeteria plans so that the plans retain their tax-favored status.

Another issue that arises with cafeteria plans is the adverse selection problem. This problem occurs because employees are likely to choose the optional benefits they are most likely to use. If enough employees do this, the cost of the benefit will eventually be driven up, as the premiums received must cover the expenditures of the benefit. For example, suppose a company allows employees to change their cafeteria plan selections once each year. During this free enrollment period, an employee who knows (or suspects) that he or she faces extensive dental work in the coming year would be more likely to sign up for dental insurance than the employee who expects only routine dental care. Likewise, an employee who has begun having vision problems would probably be more likely to sign up for vision coverage than an employee with perfect eyesight.

Sometimes employers will place restrictions on certain benefits to try to alleviate the adverse selection problem. Modular plans may reduce the adverse selection problem, as the employer can package benefits in a way that limits employees' opportunity to choose individual benefits by requiring them to choose a broad package of benefits.

In addition to cafeteria plans, companies are adopting benefit programs that offer financial incentives as a reward for employees who adopt healthy lifestyles. A 2007/2008 Watson Wyatt and National Business Group on Health survey found that nearly half of employers surveyed offer financial incentives to encourage workers to improve their health. An additional 26 percent of employers reported that they will offer similar financial incentives before 2010.

Regardless of trends in health care, the increasing diversity of the labor force means that the demand for benefit packages tailored to individual needs and circumstances is likely to remain strong. Thus, the number of companies offering flexible benefit plans and the rate of employee participation in such plans should continue to increase.

SEE ALSO Human Resource Management


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