Affordable Care & Recoverable Draws: They Don't Mix Well

Apr 7, 2015

Well, back to serious business. In a 3/26/15 blog, Prof. Annette Nellen describes a problematic consequence of the Affordable Care Act (ACA). The problem and some proposed resolutions will resonate with anyone who thinks deeply about designing incentive compensation plans, and illustrates what can happen when our legislators attempt to bake incentives and motivations into the laws they write.

Here’s the problem situation Prof. Nellen describes: A taxpayer starts the year with little or no income, and thereby qualifies for a subsidy toward his/her health insurance premium, administered through our tax system. But later in the year that taxpayer lands a higher-paying job; as a result, it turns out that the taxpayer’s annual income doesn’t qualify for the subsidy after all, so he/she must pay back the subsidy when filing the tax return.

What we have here is an approach that in sales commission plans is called a recoverable draw. It’s fundamentally an advance against future earned commissions; if commissions earned exceed the draw amount, everything is fine, but if they don’t the sales rep owes money back to the company. Recoverable draws are a terrible idea for a number of reasons, and the situation described above is one of those reasons: owing money back to your employer can be inconvenient and demoralizing, whether justified or not.

One of the proposed solutions could make things even worse: have each month’s subsidy based only on that month’s income, thereby reducing the likelihood of a yearend claw-back. As Prof. Nellen observes, that would have the effect of favoring people who – either intentionally or by accident – defer much of their income into the last month or so of the year. Such an approach might even favor people whose annual income happens to be heavily concentrated in any one or two months of the year.

This is an example of pulsing the plan, that is, behavior when incentive schemes happen to favor performance that swings wildly from month to month (or from quarter to quarter) over steady, even performance throughout the year. This particular flaw crops up alarmingly frequently in incentive compensation plans, typically because the plans’ designers simply didn’t think through the mathematics of what they were implementing.

There are ways to solve problems like this fairly and equitably, but they can be mathematically complex and require the involvement of people who think deeply about the behavioral consequences of comp plans. Alas, I fear that our senators and our congressmen are not those people.

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