By Matt Hollister, CEO, and Jim Edholm, Partner & Founder, Business Benefits

Published in Employee Benefit Plan Review

            Is a Professional Employer Organization (PEO) an appropriate option for your firm?  For decades, such organizations have offered a co-employment model for employers.  It incorporates employer-members into one mammoth organization, and one which treats their employees to benefits provided by a single organization under one tax ID number. Such an arrangement allows the employer-member to outsource many of the administrative functions to third parties, rather than carrying the full burden all by itself.  This makes for an alluring cost-and-task sharing opportunity for many companies.

However, what many employers do not realize — including many using a PEO — is it is possible, particularly with appropriate expertise, to construct essentially the same set of services at a small fraction of the PEO cost and thereby gain a greater ability to structure the level of service to each employer’s specific needs. 

The purpose of this article is to discuss and analyze five issues:

1. The services that a PEO allows you to outsource
2. Whether you should consider a PEO if you don’t currently use one
3. Identify and weigh the costs, potential risks, and rewards of a PEO
4. Evaluate the potential savings derived from creating a “virtual PEO,” i.e., a more customized and less restrictive organizational structure than that offered by the traditional PEO, as an alternative
5. Identify the necessary considerations and procedures involved in leaving your PEO if you decide to “go direct”

What PEOs Offer the Employer

To many employers the most attractive feature of a PEO is the ability to be able to hand off the burden of management of HR and benefits so that the member employer can instead focus its management energy on core business plans.  This is particularly attractive to smaller employers because it offers access to an otherwise unaffordable level of HR expertise. As a result, PEOs are widely used.

For example, the CEO of McBassie & Company reported in 2018 that 750,000 US companies with 3.7 million total employees (average size = 21 employees) have taken advantage of the PEO option.[1] However, although most firms are smaller, the employer population sizes can be wide-ranging.  A database of 131 Massachusetts companies using PEOs looked like this:

• The largest had 1,005 employees
• The smallest had 1
• The average size was 68

Clearly, there is wide variation and employers have different needs and goals.  Smaller employers may delegate the HR function to the office manager, who may not have the requisite experience with the many (and often changing) HR and Benefits compliance rules.  A larger employer might feel that the PEO would be more efficient than hiring a sufficiently experienced HR manager.

The primary rationale for retaining a PEO – at least according to the marketing of the PEO itself – is that by bundling multiple employers together it is possible to leverage efficiencies of scale.  Using a common employee benefits program, employer-participants can then share payroll and HR costs. The PEO claim is that a larger group creates administrative efficiency, greater negotiating “heft,” which thus lowers the costs of a smaller group.

Additionally, PEOs provide a “single source” for much of the administration of many aspects of Human Resources departments.  Specifically, they provide:

1. Health benefits
2. Payroll
3. 401(K) plans
4. Other Health and Welfare benefits
5. Benefit enrollment administration
6. Cafeteria Plans
7. Employment compliance assistance with Federal and State laws
8. Workers Compensation coverage

That seems like an exhaustive list, all of which appears valuable and logical. But is it in fact everything that’s needed, and everything that needs to be done?  Are there other considerations that are important but not included? 

And, of course, don’t forget that the PEO charges for its service. In that regard, how is the employer to appropriately measure the value gained for the price paid?

Health Care – the Driving Economic Argument

PEOs claim one of their most prominent advantages is saving the employer money compared to the direct cost of traditional benefits, particularly health insurance. Since the cost of health insurance is often the largest single employer cost after salaries themselves, it’s obviously critical to evaluate that claim.  If there’s not much difference in the health cost, you can then can directly compare the cost of acquiring the PEO services from the PEO vs. from individual service providers.

So let’s evaluate that PEO claim first.  In 2016 ADP Total Source, one of the larger PEOs, reported more than 400,000 “worksite” employees[2].   Because of its size ADP might claim its initial rates should be lower than direct rates from a carrier.  And it might argue that so would the renewal rates given their “purchasing/negotiating power.”

But is that necessarily true?  PEOs have been with us for more than five decades, so it stands to reason that if both the initial rates and the renewal increases were lower, the PEO rates would be a screaming bargain compared to direct rates outside of the PEO.

Yet our practical experience, working with businesses of varying sizes, tells us that the PEO rates fall within a percent or two of the rates available directly from carriers about 80% of the time.  A study in the Kaiser Family Foundation’s 2019 annual health benefits survey[3] confirms this.  In fact, this study compared average premiums for traditional non-PEO firms both small and large and found that average family premiums differed little – $20,236 for small firms, and $20,717 in large firms (surprise, surprise)!!

We therefore advise our client firms there is only a 20% chance their health care rates will vary more than 1-3% from PEO rates.  When they do vary, however, some direct rates are actually much higher than PEO rates; others are much lower.

You may ask, “Why would that be?” There are three primary reasons:

1. PEOs aren’t really like a large national employer. 
   1. Such an employer gives every employee the same deductibles, plan options, plan provisions and premium contribution
   1. On the other hand, PEOs offer multiple plans through multiple insurance carriers to their customers based on their geographic footprint.  A Massachusetts employer may be offered a Tufts health plan while a Texas employer may be offered Cigna. Each of these contain varying levels of premium, copays and deductibles.
   1. PEOs must be competitive in every industry from which they solicit business.  They compete for the business of high tech, younger firms and therefore need appropriate rates.  They likewise must compete for the business of low-tech, older, and blue-collar manufacturing firms whose rates are higher than high-tech and young. But here too, they still need to be competitive rates.
   1. PEOs must also be competitive in all areas of the country – urban, suburban and rural
2. Because they offer such a large variety of plans to such a large variety of industries, and because they’re NOT in the insurance business, they work closely with traditional insurance carriers.
   1. The carriers offer their selection of plans and break those plans into PEO “silos” based on demographic and industry profiles … the same thing those carriers do when they sell directly!
   1. The PEO thus becomes a de facto arm of the insurer, and each client’s cost is generally close to what it would be from the carrier.
3. Plans are experience-rated. Here’s where the outlier 20% that widely diverges from the carrier cost comes into plan
   1. The PEO uses insurance company plans, but those PEO plans are, in the aggregate, almost always totally experience-rated.
   1. That means the rates the PEO receives at its renewal are based exclusively on its claims, and so it doesn’t want any “clinkers” in the mix.
   1. As a result, EVERY employer in a PEO is experience-rated.

What does this effectively mean?  This short real-life example can illustrate:

• A Massachusetts Manufacturers’ Rep with 27 employees and 21 on the plan was using a large PEO.
• A group such as that would be totally pooled in Massachusetts, i.e., its rates would be based solely on the ages and zip codes of the members on the plan. 
• But NOT with the PEO.
• This group had one or more large claims in its claims history.  At their renewal the PEO informed them that they would be receiving a 47% increase in premium, which could never have happened if the employer had contracted directly with the carrier and was pooled with multiple other employers.
• In fact, the employer was able to leave the PEO, with a similar plan (reducing employee disruption) at a rate that was slightly less than the expiring rate that had been scheduled to rise by 47%.

While it’s impossible to identify in advance where a given employer’s rates would be if placed directly, we can reaffirm our guideline: 80% of employers’ premiums generally fall within ± 1-3% of the PEO rate, and the other 20% differ wildly, either higher or lower. That 20% and the size of the cost spread justify shopping the market, as illustrated by the story above.

Other Considerations Count, Too

Above, we listed eight areas where PEOs provide services to employers, and they’re important.  Though they are perhaps not as economically impactful as the Health Care relative cost differences, they are important nonetheless.

Dental, vision, life and disability insurance are also available via PEOs. This is where the PEO generally provides premium savings. These plans tend to have a national scope with fewer plan design variations than health care which is an extremely “provincial coverage,” varying both from state to state and even within states.  Simplicity of these plans’ design confers instead simplicity of administration.

Likewise, these coverages offer higher margins and fewer state-mandated restrictions to their carriers than does health care insurance, so carriers can be more aggressive in their pricing.  As a result, the PEO price for them is often less than the employer can obtain directly.

However, because these plans are low-cost compared to health insurance, they typically only account for 10-15% of the total premium the group will put through the PEO.  So if those premiums are 20% cheaper but only account for 15% of the total premium, you can readily see that the PEO will generally only offer overall premium savings of 3%. Nice, but not compelling.

Earlier we also mentioned other services – Payroll, 401(K) plans, Benefit administration, Cafeteria Plans, Employment Compliance Assistance and Workers Compensation coverage.  For a smaller company those are daunting areas of concern for sure.  Since a smaller company can’t usually justify the expense of a full-time HR manager, joining a PEO may seem like a smart choice.

But if you look more deeply, what’s the most important aspect of an employer’s responsibility vis-à-vis employees?  Arguably, it’s hiring and training.  And who will do the hiring and training? The PEO? No, sorry, that’s still you, the employer.

Employee records, e.g., I-9 forms, beneficiary tracking, time and attendance tracking: Such tasks as these largely remain the employer’s obligation. Though PEOs will occasionally provide a phone-in HR “manager” to answer specific questions –assuming you know the correct question to ask—that is often the extent of their assistance in these matters..

The point is, having a PEO still leaves you with lots of essential functions and plenty of potential employment practice liability.  While the PEO offering includes some level of employment practice liability insurance (to protect themselves as the employer of record), it doesn’t protect you against the errors you might make in hiring, training, or other employee-related actions.  So joining a PEO doesn’t completely eliminate the liability for employers.

The ROI Comparison Rationale

Here’s where the rubber meets the road.  How much does a PEO cost, and what options do you have if you would still like to be able to farm out the tasks that a PEO provides?

PEO pricing varies widely, but we have found a useful estimate to be $1,200-$1,500 per employee per year (PEPY).  The cost of finding and assembling a team of individual vendors to provide the same level of services is typically about 20% of the PEO cost. That’s a significant difference ($960-$1,200 per employee per year) and it probably justifies doing the work involved in measuring the savings from the two options, i.e., actual PEO vs. a more customized virtual PEO.

 There are three possible outcomes, and each depends on the relative cost of health insurance provided by a PEO as compared with the cost of contracting directly with an appropriate carrier.

• If your firm is in the fraction of employers where there is a significant savings via the PEO providing your health insurance, you may find the $1,200-$1,500 PEPY cost, when reduced by the PEO health care savings (compared to the cost of commercially acquired coverage), is sufficient to justify remaining or contracting with a PEO.
• If your firm is in the fraction within which your commercially acquired health insurance is less expensive than the PEO, then a cost of $1,200-$1,500 PEPY will probably be prohibitive when combined with the additional cost of the PEO-provided coverage. 
• If the cost of the coverage is – as is usually the case – comparable between the PEO and commercially acquired coverage, then it will be necessary (or at least desirable) to determine whether creating your own “virtual PEO” so as to harvest the $960-$1,200 savings is worth the extra time and trouble.

Comparing PEO Cost to “Virtual PEO” Cost

The comparison effort of evaluating whether to join a traditional PEO or set up a more customized Virtual PEO structure strongly suggests that you work with an advisor who has done “PEO evaluation and deconstruction” before. If you look back at the list of services involved in a PEO, you see that there are a lot of disciplines involved in the process. 

• First, there is insurance knowledge involved in comparing health, life dental, disability, vision and voluntary benefits. Points to consider:
  • Specifically, you should assure as best as possible that the actual rates that are put into effect are the same ones you use during the transition … employees hate surprises!
  • Moving from one plan to another can cause disruption in the network, thus it’s useful to work with an advisor who can do a primary care match between current and upcoming networks.
  • Prescription formulary differences can also be disruptive; however, that falls into the purview of the employee himself or herself.
  • Beneficiary designations are the ultimate responsibility of the actual employer, not the PEO, so those will need to be checked when changing life and 401(k) plans.
  • Employees not actively at work won’t be covered under the life, LTD and STD plans unless the “actively at work” requirements are specifically waived by the new carrier.
• Second, worker’s compensation is a requirement and the employer should evaluate its options outside of the PEO. On the other hand, employment practices liability is not mandated and so may be included only to a limited degree in an employer’s general liability coverage. These plans should therefore be evaluated by an experienced property and casualty agent.
• Third, payroll continues irrespective of whether you have a PEO.  Perhaps your PEO provider can provide just the payroll costs.  Many PEOs sprang up from a payroll company, and many are willing to allow you to spin off the other PEO-related functions. Consider:
  • If you’re currently using a PEO and decide to look at individually executing the component steps, you will need to reactivate your company’s Tax ID number.
  • Further, if you exit the PEO on a non-calendar year, your employees are technically “new employees” and their status and Social Security wage withholdings will be re-set.  The employees will get the supplemental withholding refunded, but you must think about the communications.
• Fourth, your 401(k) plan via a PEO is a “Multiple Employer Plan” or “MEP.”  Rolling out means you need to start a new 401(k) plan, even if you’re going to use the same 401(k) provider.
  • There are three legs to the 401(k) stool.
    • The provider or record keeper
    • A Third Party Administrator (TPA)
    • An Advisor
  • The record keeper is the most employee-visible, and usually a change here can cause disruption.
  • The communication between the record keeper and the payroll provider is essential.  We’ve found that having bi-directional connectivity between payroll provider and record keeper assures the least “change disruption” in the 401(k) process.
  • The TPA is the paperwork provider … plan documents, paperwork for loans, distributions, and annual filings.
  • The Advisor helps employees select appropriate investment options, etc. 
• Fifth, compliance with Federal and State laws and reporting requirements is important for employers to stay in cadence with.  Your advisor should be able to help you establish a satisfactory source of compliance support.
• Benefit Administration is another key facet of a PEO, either actual or virtual.  Providing onboarding, open enrollment, easy access to questions about benefits, etc. is of particular relief to the HR Department, since most of the angst employees face is directed at them.
• Workers Compensation Insurance is – generally – easy coverage to acquire, and many carriers have cash-flow-advantageous methods of collecting premium.  There may be some challenge if your firm is in an industry that comp carriers find risky, or if you have experienced high claims in the past. 

As can be seen, the decision to select between a traditional PEO and a Virtual PEO isn’t a simple or quick decision.  In fact, our experience has been that companies with fewer than 50 full time employees should allow at least 60 days, and those larger than 50 should ideally get the evaluation started at least 90 days in advance. But the exercise can be impactful. 

For example, the company mentioned above, that was facing a 47% increase, went through this exercise.  Here are the results:

1. It avoided the 47% increase, which would have annually cost the employer an additional $101,605/year and employees $42,253
2. Health costs dropped by 1.6% for the same plan from the same carrier 
3. The company’s new “Virtual PEO” gave it individual control over the selection of vendors for the PEO services it needed.  Now if one vendor disappoints, this firm does not need to change its entire PEO … it can simply replace the offending vendor
4. And with this deconstructed Virtual PEO, it saved a further $32,400 in out-of-pocket administrative costs without eliminating any services 
5. This was a firm with 27 full-time employees, resulting in employer savings on a PEPY basis (including the premium increase they avoided) of $4,963 PEPY. Not bad!

Does it always work out that well? Of course not, but the potential reward would certainly seem to offer significant opportunity to the serious management team. Multiply your full-time employment times $960-$1,200 and you will get a pretty good feel for the amount of cash expense you can avoid without having to sacrifice few or any services.

NOTE: If you would like a more detailed examination of your specific situation or the process described here, simply send an email with your physical mailing address to jedholm@bbibenefits.com to request a complimentary copy of The Case for Direct Employment Plans vs. PEOs, the white paper byMatt Hollister, M.P.H., BBI’s CEO, upon which this article is based.

Matt Hollister is CEO of Business Benefits, an employee benefits advisory and broker age with three offices in Massachusetts (Amherst, Andover, Concord). Originally founded in 1982 by co-author Jim Edholm, BBI represents over 500 US client companies mostly in the Northeast.  Matt also founded Hollister Insurance in 2000, which merged with Business Benefits in 2018.

Matt earned his B.A. from Northeastern University and an M.P.H. from Boston University where he concentrated in Health Care Policy.  In addition to holding life, accident and health producer licenses, Matt is a registered investment advisor, has earned his Insurance Adviser’s license in Massachusetts and has recently become a Health Rosetta certified health advisor bringing high performing health plan options to his clients. Email: mhollister@bbibenefits.com or visit https://www.bbibenefits.com/

Jim Edholm is Partner & Founder of Business Benefits. Originally a Midwesterner (Jim refers to himself as “just a Chicago kid”), he migrated to New England in 1972. He began selling benefits in 1983, founded BBI in 1992, and has prided himself ever since on a commitment to seek out the most cost effective, cutting-edge strategies available to privately held businesses in need of such solutions. Email: jedholm@bbibenefits.com or visit https://www.bbibenefits.com/

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[1] Bassi, Laurie (September 2018). “An Economic Analysis, The PEO Footprint 2018”. NAPEO Whitepaper – via Whitepaper

[2] https://money.cnn.com/news/newsfeeds/articles/marketwire/1241964.htm

[3] http://files.kff.org/attachment/Report-Employer-Health-Benefits-Annual-Survey-2019