By: HUB’s EB Compliance Team

Most employers adjust contributions for their benefit plans at the start of each plan year. Contribution changes (both mid-year and at renewal) sometimes lead to questions regarding certain employees.

Grandfathering Rationale

Employers typically consider grandfathering employees as a way to keep rates the same or relatively constant for current employees, but charge new employees higher rates for those same benefits. Though this is often driven by financial considerations, this strategy is designed to limit disruption for current employees by limiting any rate increases the employer would otherwise have to pass along to all employees. Depending on the employer’s goals and budget, the rates before and after the cutoff date may vary significantly.

Nondiscrimination

Grandfathering could be discriminatory under the nondiscrimination rules of §125 and §105(h) of the Internal Revenue Code. Generally, these rules prohibit employers from favoring highly compensated employees within their benefit plans. As a reminder, §125 applies to all benefits (regardless of funding) which are included in the employer’s cafeteria plan, whereas §105(h) only applies to self-insured health (medical, dental, vision) benefits, which includes level-funded plans.

Highly compensated under §125 is someone (1) who made more than $155,000 (for 2024 testing and $150,000 for 2023 testing, adjusted annually) in the year before the year being tested, (2) owned more than 5% of the stock/equity of the employer in the plan year being tested or the plan year just before it, (3) officers, and (4) spouses and dependents of (1)-(3). Under §105(h) highly compensated means (1) one of the five highest-paid officers; (2) a shareholder who owns more than 10% of the value of stock of the employer's stock; or (3) among the highest-paid 25% of all employees (other than excludable employees who are not participants).

When an employer grandfathers current employees, the majority of highly compensated employees will likely be in the grandfathered group to start since longer tenure usually leads to higher compensation. This means the grandfathering arrangement will favor the highly compensated employees. Only after the employer hires highly compensated, non-grandfathered employees may the plan pass nondiscrimination testing.

Affordable Care Act

Under the Affordable Care Act’s employer mandate, an applicable large employer is generally required to offer at least one health plan that provides affordable, minimum value coverage to its full-time employees (and minimum essential coverage to their dependents) or pay a penalty. Employers need to be conscious of affordability when considering grandfathering because both grandfathered and non-grandfathered employees must be offered affordable coverage.

Affordability is based on the coverage actually offered to employees. This means if grandfathered employees are offered employee only coverage for $100 per month, but non-grandfathered employees must pay $180 for the same coverage, the employer must use $180 to calculate affordability for the non-grandfathered employees. When completing their ACA reporting, the employer must identify which employees are offered coverage at which rates.

Other Considerations

Grandfathering employees may also cause a divide between longer tenured employees and those newly hired. The different rates may foster resentment between the grandfathered employees and those who are non-grandfathered. This is especially likely if the employer has both classes of employees performing the same roles at the same locations.

Grandfathering may also foster an arbitrary “winners” and “losers” environment. For example, assume ABC Corp determines that employees hired after April 1, 2025, are non-grandfathered and must pay higher rates. If ABC Corp hires Pam on March 29, 2025, and Jim on April 2, 2025, Pam “wins” while Jim “loses” even though they started just a few days apart. Over time, this feeling may be magnified as Pam’s savings may be considerable as compared to the rates Jim must pay for coverage.

Employers should be cautious about over promising to employees in the grandfathered class. Over promising could mean representing that employees in this class will remain in this class for any set amount of time, or indefinitely. This could also mean promises to keep current contributions as is, without any changes. Over promising can only lead to not meeting expectations should the employer ultimately be unable to deliver on those promises.

When an employer establishes a grandfathered class of employees, this is the employer’s own doing. Employers must follow their own rule. For example, if ABC Corp were to hire Michael as a regional manager after the cutoff date for grandfathered employees, Michael is a non-grandfathered employee. ABC Corp does not have any flexibility to move Michael into the grandfathered class of employees, so he pays lower rates for coverage. ABC Corp may have a difficult time delivering this message, especially as Meredith, who reports to Michael, is a grandfathered employee. Michael may also not be happy about this and may consider offers from other potential employers.

Conclusion

While there are certain financial benefits associated with pursuing a grandfathering strategy, these benefits come with a cost. Employers need to decide if the compliance risks and the potential for employee disruption are worth the cost savings.

If you have any questions, please contact your HUB Advisor. View more compliance articles in our Compliance Directory. 

NOTICE OF DISCLAIMER 

Neither Hub International Limited nor any of its affiliated companies is a law or accounting firm, and therefore they cannot provide legal or tax advice. The information herein is provided for general information only and is not intended to constitute legal or tax advice as to an organization’s or individual's specific circumstances. It is based on Hub International's understanding of the law as it exists on the date of this publication. Subsequent developments may result in this information becoming outdated or incorrect and Hub International does not have an obligation to update this information. You should consult an attorney, accountant, or other legal or tax professional regarding the application of the general information provided here to your organization’s specific situation in light of your or your organization’s particular needs.