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Cafeteria Plans

What is a Cafeteria Plan?

Cafeteria plans are defined under Section 125 of the Internal Revenue Code as plans maintained by an employer that allow each participant to select among cash and one or more qualified non-taxable benefits. This is the technical definition, but in practice a cafeteria plan (sometimes called a flexible benefit plan) is a benefit plan that allows an employee to have some choice in designing his or her own benefit package by selecting different types and/or levels of benefits that are funded with nontaxable employer dollars.

Why do Employers Propose Cafeteria Plans?

Many employees are initially enthusiastic about cafeteria plans because they believe that they will be able to acquire new benefits, such as child care assistance or orthodontia coverage, which they believe will suit their particular needs. However, Unions and their members need to be very wary of proposed cafeteria plans. Many employers implementing cafeteria plans claim the plan will better meet individual needs. The reality is that most employers introduce cafeteria plans to reduce employer benefit costs. Many employers with newly implemented cafeteria plans changed their medical plan design by raising deductibles and/or increasing employee contributions. Satisfying diverse employee needs is, at best, a secondary objective.

How does a Cafeteria Plan Work?

• The most common type of cafeteria plan provides a basic core of benefits including minimal levels of medical and life insurance, sick leave or disability benefits, plus a second layer of optional benefits. At a minimum, the basic benefits should provide a reasonable level of protection against the major sources of personal risks. The employee can select the core benefit, or alternatively, purchase a higher level of benefits with cafeteria dollars. The plan might also add benefits that were not previously offered as options.
  
  
• Each employee is allotted a predetermined number of dollars, credits, or points with which he or she may purchase benefits from options made available by the employer. If the dollar amount allotted by the employer is inadequate to purchase the desired benefits, some plans allow employees to make additional purchases with before-tax contributions through payroll deduction (See factsheet on Flexible Spending Accounts). If the benefits selected cost less than the allotted amount, the employee receives the difference in cash, if the plan so provides. The cash amount is taxable as ordinary income.
  
  

What Benefits can be Included in a Cafeteria Plan?

• Benefits which can be offered in a cafeteria plan include most benefits ordinarily resulting in no taxable income to employees if provided outside of a cafeteria plan. Some examples are: health, dental and life insurance, accidental death and dismemberment coverage, disability coverage and vacation leave. One exception, group life insurance in excess of $50,000, which is normally taxable, can be included. Although the inclusion of life insurance coverage is permitted, the amounts in excess of $50,000 continue to be taxable.
  
  
• Although scholarships, fellowships, transportation benefits, educational assistance, and employee discounts are not taxable benefits, they are an exception to the above rule and may not be included in a cafeteria plan.
  
  
• A cafeteria plan cannot include retirement benefits except under a 401(k) plan. However, because the regulations governing 401(k)s are so complex, especially when combined with IRS Section 125 regulations, many employers will not allow their inclusion in a cafeteria plan.
  
  

Possible Problems

The appeal of cafeteria plans is the flexibility which allows employees to select benefits that meet what they believe their needs will be. While the concept of cafeteria plans may seem appealing, serious potential problems do exist, including the following:

• Unwise Employee Benefit Selection

  Employees may not have the expertise to select the proper benefits from the alternatives offered. An unwise selection can result in inadequate employee protection and catastrophic losses. For example, younger employees may elect cash in lieu of a high option health plan or disability coverage. What happens if that employee becomes seriously ill or disabled?
  
  

• Reduction In Previously Negotiated Benefits

  As part of a cafeteria plan, the employer usually proposes reduced levels of current benefits as the core coverage and then offers a "menu" of various optional benefits. Because cafeteria plans require greater administrative costs than traditional benefit plans, the allotted cafeteria dollars are normally less than the dollars that would be needed to purchase the level of benefits in effect under the traditional plan.
  
  

• Impact On Future Negotiations

  Under cafeteria plans, the employer designs the benefit package to meet the desired cost. As the cost of a core benefit increases, the employer may attempt to redesign it to stay within the targeted dollar amount. The increase in the employer's contribution should correspond in the same amount as the increase in benefit costs. Otherwise, benefits will likely be reduced as the costs increase.
  Also, when the union proposes to add a new benefit to the plan, management's response may be to include it as an option. Negotiations can be then reduced to bargaining only for the dollar amount contributed by the employer rather than for additional benefits.
  
  

• Determining the Value of Credits

  As mentioned earlier, employees are allotted a predetermined number of dollars, credits, or points to be used to purchase benefits. AFSCME recommends the use of credits or points because dollar values are eroded as benefit costs increase.
  
  

• Adverse Selection And Benefit Cost Fluctuation

  Employees who are likely to have claims will tend to select the benefits that will minimize their out-of-pocket costs. For example, employees might elect dental coverage until they have all of their necessary dental work completed, and then drop the dental plan. The cost of the dental program would increase substantially in the next year in order to cover the high claims of the prior year. Costs will likely be higher under a cafeteria plan because the covered group will probably always represent the poorer risks.
  
  

Limited Cafeteria Plan

AFSCME believes that limited cafeteria plans are appropriate when employees and their dependents are fully covered by health, dental, vision, health screening, hearing, well-baby care, life insurance and disability plans.

A limited plan may offer spending credits or dollars to be used to purchase non-traditional benefits such as increased vacation days, child care, term insurance on dependents, financial counseling, additional life insurance and/or legal services. If the union is considering participating in this type of program, the choices offered and the level of benefits should remain subject to negotiations.

AFSCME Research Department
October 2001
 

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