PEO Economics: An Inside Look

As employee benefits and group health insurance costs continue to rise, regardless of the general economy’s inflationary indicators, human resources professionals and CFOs are urgently seeking ways to mitigate the impact. One option that offers a compelling alternative is partnering with a Professional Employer Organization (PEO). This model is particularly appealing for employers with 2-50 (up to 100 employees in states such as California) who have been siloed into the small group healthcare market due to the Affordable Care Act (ACA). Despite its advantages, PEOs have a market penetration of less than 5%, making them a relatively new concept for many companies. This unfamiliarity often leads to misunderstandings about the true costs of this business model. To avoid costly oversights, here are some potential pitfalls to consider. Executives and HR leadership, along with partners such as employee benefits advisors, need to peel back the layers of the onion to truly discern viable business strategies and whether a PEO is worth entertaining.

Understanding How a PEO Works: A PEO operates under a co-employment arrangement where it becomes the "employer of record" and uses its Federal Tax ID number to pay employees. Meanwhile, the client remains the "worksite employer," retaining responsibility for hiring, firing, setting wages, and overseeing day-to-day activities. Although the transition is relatively seamless for employees, they technically become employees of the PEO. This co-employment relationship gives clients access to the benefits and negotiating power typically reserved for larger employers (100 eligible employees and above).

Advantages of a PEO: PEOs offer a range of benefits, including access to large group insurance products, consolidated billing for various services (HRIS/Payroll, healthcare, COBRA, FSA, workers' compensation, benefits administration, etc.), HR consulting, and risk and safety guidance—all delivered through a streamlined user interface. The model is particularly suited to smaller employers under 50 employees, as the average PEO client has fewer than 25 employees. Small companies often lack dedicated HR resources and access to large-group employee benefit plans, making a PEO an attractive, turnkey solution for HR, payroll, benefits, and workers' compensation insurance. This allows CFOs and business owners to outsource HR functions and focus on strategic initiatives. However, as companies grow, they typically benefit from in-house HR professionals, and the fees associated with a PEO can become cost prohibitive.

Key Considerations: Having assisted several clients in implementing a PEO and more frequently helping employers move away from PEO’s, I've found that success hinges on thorough evaluation and stakeholder buy-in. A human resources executive once told me that while PEOs can be a CEO's dream (offering consolidated billing and big-company benefits), they can also be a CFO's and HR’s nightmare due to a lack of billing transparency and reduced flexibility. Here are some economic factors that are often overlooked or misunderstood:

1. Administrative Fees: These typically range from $1,500 to $2,500 per employee annually. Some PEOs bill their fees as a percentage of payroll, bundled with employer taxes, workers' compensation, and sometimes healthcare costs. Others charge a flat fee per employee per month (PEPM). Be cautious when fees are calculated as a percentage of payroll; a lucrative year of employee bonuses will also result in a bonus for your PEO. For example, we have come across scenarios where the client has bonused Executives which resulted in pure profit to the PEO (ie. $500,000 bonus to the CEO, resulting in an $7,500 administrative fee to process a single check (1.5% of payroll)).
2. Increased Tax Liability: In a PEO arrangement, administrative fees and employer taxes (FICA and unemployment) are usually based on the gross payroll. This means healthcare expenses are not deducted when calculating payroll taxes. For instance, if your payroll is $5 million and your healthcare spend is $1 million, you would pay employer taxes on $4 million ($5M - $1M) in the open market. With a PEO, you would pay taxes on the full $5 million. With FICA at 7.65%, this extra $1 million in taxable payroll results in an additional $76,500 in tax liability per year.
3. Health Renewals: A common misconception is that PEO renewals are more favorable than those in the open market. However, this isn't necessarily true. While initial rates may be lower, year-over-year renewals often follow market trends. If the loss ratio is unfavorable (meaning the insurance company pays more in claims than it collects in premiums), the PEO is likely to pass on a significant increase, much like traditional insurance carriers. This practice helps protect the PEO's book of business and benefits clients who perform well.
4. Workers' Compensation for Owners: Since all payrolled employees become employees of the PEO, they must be covered by workers' compensation, including the owners. While the costs are generally minimal unless the owner is in a high-risk classification, it's worth considering. If the PEO allows, ask to cap the payroll amount for which owners will pay workers' compensation. While this may not be a significant cost factor, it can add up with multiple owners and substantial payrolls.

As employee benefits advisors, we often help clients evaluate the pros and cons of PEOs versus traditional employer/employee relationship. Having started my benefit advisory career at one of the largest global insurance brokers, 90% of the time spent with PEO arrangements at the time was facilitating the movement of growing businesses away from PEO’s.? Most found through cost analysis and supporting data, they had outgrown the PEO model.? The lack of education around the PEO model within the benefits broker community often leads to a knowledge gap among HR professionals and Executives. While PEO adoption is on the rise and can be a viable model for many companies, it's crucial for employers to approach the evaluation process with a clear understanding of the potential costs and benefits. Optimal Benefits Professionals