The Dark Side of Outsourcing

It starts innocently enough. Your HR organization is overburdened with administrivia.

You wake up one morning and think, “Hey, my team doesn’t have to deal with the daily details of administering our benefits plan—we could outsource it.” When you get to work, you call the big consultants to get their expert advice. After all, you’ve never outsourced, so you need to know if it’s really the right thing to do. You get advice, call vendors, solicit bids, select a vendor, negotiate a deal and finally, you turn it over. You think: “Ahhh. It’s a done deal.” You’re happy you can finally relax.

For a while, everything seems to go along fine. Then you start getting phone calls from your benefits reps. Employees’ questions aren’t being answered correctly, or they’re getting conflicting information. Or worse, they can’t even get someone on the line at the service center that’s supposed to be picking up the calls.

More problems start to surface when you ask the vendor for service reports. It either can’t run them to your specifications or can’t run them at all. You panic and call your benefits-vendor contact. “Brett no longer works here. We were acquired by another firm,” says the receptionist. “I think your new contact is Sylvia, but she’s on vacation. She’ll call you back in two weeks.” Click. From there, service levels and supplementary costs continue to spiral out of control. This isn’t how you imagined outsourcing. No one does.

But somehow, somewhere along the line, what was intended to be a cure-all has instead become an outsourcing nightmare. You’re hoping to wake up and discover it has all been a bad dream—but you don’t.

Actually, you might be surprised to learn you’re not alone in this nightmare. According to the “Strategic Benefits Sourcing Practices 1998 Survey” by The Hay Group, an HR consulting firm based in Philadelphia, 57.2 percent of the 132 firms surveyed said they currently outsource group benefits claims administration or service center functions (a customer-service function that answers em-ployee questions about group benefits claims). Of the 57.2 percent in Hay’s survey who currently outsource this function, 19.3 percent said they were “not satisfied.”

And it gets worse. Of the 9.2 percent of firms that use outside vendors for group benefits enrollment (administrative support of the initial group enrollment process, special support for annual open enrollments), 23.1 percent said they weren’t satisfied with the outsourcing relationship. That’s nearly a quarter of them.

And “The 1998 Outsourcing Survey” by The Segal Company, an HR and outsourcing consulting firm based in New York City, indicates an even bleaker picture of HR outsourcing in general—not just benefits outsourcing alone. Says Jack Walsh, recently retired practice leader of Segal’s HR consulting practice: “About 25 percent of the people who’ve outsourced [any type of HR function] that we’ve talked to this year indicated they’ve experienced disappointment.” The numbers aren’t pretty. But they’re real.

Workforce has worked hard over the past several years to give you a clear picture of HR outsourcing, starting with “Why HR Is Turning to Outsourcing” in September 1993, when we discussed the positive attributes of sending HR functions and services to outside companies. Five years later, 75 percent of outsourcing customers are satisfied with what they’re getting.

Now that HR executives have had at least five years of outsourcing experience, we wondered why you never hear about the 25 percent of outsourcing relationships that go sour. You never hear about the botched systems, missed deadlines, boggled communications and hundreds of staff hours lost. And what about angry employees, retirees and unions that file lawsuits over bungled outsourcing screw-ups? You certainly never hear about the HR executives who’ve been fired over multimillion-dollar outsourcing contracts that failed. But these nightmares are happening—daily.

If you’ve never outsourced, but are considering it, this will help you become more aware of the potential problems. Or if you have already outsourced and are currently satisfied, you can still learn what the biggest problems are from those who’ve seen the dark side of outsourcing, so you can avoid future problems.

Few will talk about outsourcing failures.
You should know that most outsourcing vendors don’t want to talk about problems. Several HR outsourcing firms were contacted for this story, and while each boasted of its successes, they wouldn’t discuss any client problems. For example, the vice president of sales for one vendor specializing in hiring-process outsourcing for some Fortune 500 firms declined to be interviewed on this topic. Representatives of other HR outsourcing services, such as pension administration, payroll and recruitment consulting, also declined to be interviewed for this story.

To be fair, these firms probably provide top-notch outsourcing services to their clients—yet behind the scenes, there’s evidence of major HR outsourcing failures. For example, Bethesda, Maryland-based Watson Wyatt & Co.—through its spinoff venture with State Street Bank and Trust Co. and Wellspring Resources LLC—announced in a U.S. Securities and Exchange Commission Form 8-K filing on April 21, 1998 that it’s discontinuing its foray into the benefits-outsourcing marketplace. This move has left its clients—such big-named firms as Sears, Westinghouse and Rockwell—scrambling to figure out what to do next.

When asked to comment on its failed relationship with Watson Wyatt, one of its client firm’s representatives (who asked not to be identified) said: “Off the record, it’s a sensitive subject. A lot of people’s jobs are at stake.” Another client said: “It has been a tug-of-war throughout the whole process. I’m glad it’s over.”

It’s equally difficult to get clients of outsourcing relationships gone awry to speak about the problems they’ve had, though there are a few that will. For example, Jerry Pena, the HR manager for DACCO, a substance abuse treatment provider in Tampa, Florida, has had a couple of disasters with HR outsourcing providers.

DACCO, which has 13 offices and 190 employees, outsourced its defined-contribution pension plan—401(k)—to a Tampa-based pension vendor in July 1996. “Our motivation at first was to try to remove some of the administrative burden on us because pension plans had become so technical,” says Pena. In the beginning, he thought that getting a third-party administrator to handle the firm’s 401(k) was a great idea. He assumed the vendor would also have some of the technical expertise DACCO lacked among its four-person, in-house HR team.

“It has really been one of those situations in which somehow, somewhere, we lost control. We bought a bill of goods that was probably not what we thought we were buying,” he says. “The promise of support we thought we were going to get is nonexistent. I do more work now on it than I did before, yet I’m paying somebody else to do it.”

For instance, he assumed that upon an employee’s termination, the 401(k) vendor would send the distribution information packet to the employee about his or her pension plan. At first, the vendor did send these packets directly to employees. Now, Pena says the vendor sends him the packets, and his team has to send them to employees. “All of a sudden we became the middleman for things we had no idea we were going to be doing,” says Pena.

When Pena explains the problems with the company’s outsourcing relationship, he admits he has to share the blame. He says on DACCO’s part, it didn’t have one lead person involved in the negotiation and communication with the vendor. But as for the vendor: “[The] company is very [adept] at throwing stuff right back on your lap.” What has he learned? His inexperience in his first attempts at outsourcing, combined with a poor choice of vendors, has resulted in some outsourcing disasters. He says he’s shopping for new vendors and won’t be so naïve the next time around.

Pena’s situation isn’t unique. Out-sourcing contracts are being renegotiated right and left. It makes you wonder where the outsourcing problems really lie.

Yes, it all boils down to money.
Most vendors won’t tell you about potential outsourcing problems, but some consultants who HR executives hire to get outsourcing advice will. According to them, the biggest reasons for outsourcing failures are: lack of proactiveness by the vendor, turnover of the vendor team, vendor errors and mistakes, incompatibility between client and vendor cultures, data transmission errors, technological inefficiencies and contract ambiguities.

But the most troublesome areas are surfacing in the realities of control, service levels and, most notably, costs. “The biggest horror stories about outsourcing relationships gone awry these days is around the issue of costs,” says Greg Hackett, president of The Hackett Group Inc., a Hudson, Ohio-based consulting firm known for its HR benchmarking studies in the knowledge-worker field. He adds: “The white lie of outsourcing is that it’s a silver bullet guaranteed to lower costs and reduce the worry. Instead, costs often increase and headaches multiply because outsourcing is undermanaged and poorly monitored.”

In fact, The Hackett Group’s 1998 “Best Practices Benchmark Study of HR” of more than 1,200 companies worldwide shows that outsourcing remains a major HR expenditure. The cost to perform outsourced functions can run as high as $415 per employee annually, on average, or 28 percent of total per-employee HR costs. However, only 1.6 percent of HR time is typically spent managing third-party suppliers, and the expected reduction in costs often doesn’t materialize.

“Here’s the bottom line: When you outsource, your costs can run as high as seven percent higher than if you did it inside, and did it right,” says Hackett. He thinks most companies can do a better job of administering HR processes more cheaply in-house.

That doesn’t mean they should move processes back in-house, even with all the potential problems of outsourcing. Much has been written on why focusing on HR’s core values is still a good idea. But the biggest problem with outsourcing lies in the misperception that it will cost less. It usually doesn’t.

Here are the shocking specifics. Vendors make their money by profiting on your inefficiencies. It’s cheap for a vendor to process what Hackett calls clean transactions. That means you might pay 27 cents for them to process an ordinary benefits transaction. But if there’s a problem that can’t be resolved in the first pass, you might have to pay $4.25 for the same transaction. Hackett explains: “They’re smart. They have learned to make their money on the exceptions—the problems.”

Here’s the other shocker: You could be driving the costs up by making the process more complicated than it has to be. “There are a lot of companies that will go to a third party and say: ‘We want [our transactions] on blue paper, horizontally, with three holes punched at the top and, oh, it has to be in Swiss font 14,’” explains Hackett. Vendors usually have a standard process. The more complex and specific your demands, the more you’ll be charged for them.

Then there are costs associated with what Hackett describes as bad interface. If you want vendors to do a lot of manual entry related to your account instead of delivering data to them electronically, or if the interface from your computer system isn’t straightforward, they’ll charge you for those incompatibilities or differences. “And finally, there’s the cost for just being a pain in the ass. And it’s a huge cost,” he says. Hackett figured out that one of his clients paid $24 million a year in penalties for its unrealistic standards, such as requiring a 98 percent compliance standard from the vendor instead of the originally agreed-upon 97 percent. The translation: There are no free rides.

oss of control and service quality are intertwined.
A small May 1998 survey regarding outsourcing by Workforce reveals that 46 percent of 13 respondents said they were frustrated by the level of service or quality of product that their outsourcing vendors provide.

“Most organizations really have problems defining their current service levels,” says Larry Cabler, director of consulting services for IBM’s Employee Services Group, a part of IBM’s Global Services unit. Cabler has seen outsourcing from both sides—first as an HR executive in IBM’s internal HR function, and now as a consulting expert for IBM’s HR outsourcing team that provides strategies for clients in all areas of HR services. Cabler, who admits he experienced outsourcing problems with other vendors when he was on the client side, points out that many firms make the mistake of trying to shop out a job they really don’t fully understand to begin with.

Take Ryan Smith (not his real name), for example. Smith talks about the service-related problems his firm has suffered with a pension administration vendor: “When we entered into the contract five years ago, we went into the deal with rose-colored glasses. Even though our vendor had just entered the marketplace, its reps professed to be the experts be-cause of their past consulting experience,” he says. “In the end, they didn’t provide the services we thought we’d be getting on the level that was required for our size of contract and in the ways we’d come to expect as a company.” The vendor had promised to provide better, faster service to employees and retirees.

Smith’s HR team learned the hard way that even though the vendor’s processes and systems were newer, they had so many bugs (at last count, there were more than 5,000) that its speed and quality output were dismal. The error rate in testing has been 50 to 65 percent. “The system the vendor boldly said was state-of-the-art to hook us in, is really anything but,” he adds. The problem is that Smith’s company believed the vendor could easily customize its system to meet the requirements of administering its multiple, complex pension plans, based on bells and whistles demonstrations, and promises of capabilities not yet in existence. “We wanted to believe they could do it, and they wanted to believe it, too,” says Smith. The lesson here: Be certain the vendor’s existing production system can meet all your needs before inking the deal.

The potential disasters that could have resulted send Smith into a cold sweat just thinking about them. Smith imagined calculations being screwed up, people getting checks for the wrong amounts, the company being sued by the participants of the plan, the company being sued by the Pension Benefit Guarantee Corp. and being taken to court under ERISA. It was a nightmare that looked to get worse. Fortunately, the vendor decided it wasn’t very good at this type of outsourcing and is getting out of the pension administration business. Now, of course, Smith’s firm must figure out what to do with the outsourced function next.

As if service nightmares aren’t enough to scare you, consider the issues related to the loss of control that HR managers often experience when faced with outsourcing. Take Norris Overton, for instance. Until recently, Overton was the vice president of customer and employee satisfaction for Washington D.C.-based Amtrak and is now the director of business development at Radcor Technology Inc. in Bethesda, Maryland. Overton often gives speeches nationwide about the pros and cons of outsourcing and the lessons he has learned from past outsourcing relationships. He consulted with Amtrak’s in-house HR team when it outsourced the firm’s benefits administration.

In a spring 1997 article that appeared in The Source, (published by New York City-based The Outsourcing Institute), Overton talks about outsourcing information systems functions, the data center and communications network when he was the decision maker at Amtrak. “Control was a major issue for us,” says Overton. “We didn’t have control over those functions in-house when the system used to crash before we outsourced it to IBM. As long as the system was down, we were out of business.” He thinks Amtrak gained control by outsourcing these functions be-cause the vendor promised in the contract that the system would be up and available 98.9 percent of the time. “IBM could promise that because it has backup sites around the country which we didn’t have,” says Overton. “With an outsourcing contractor, we could specify a service level and demand to have that service level met by a contractual arrangement, and instill penalties if that service level wasn’t met. Basically, outsourcing increased our control.”

But beyond service issues, Amtrak execs also had to iron out issues involving executive compensation, since outsourcing means having fewer direct reports, and many directors were paid based on the number of people they supervised. Plus the basic issue of trust always surfaces. “So there was always initial resistance: ‘Can we really trust this important function to an outsider?’” says Overton.

You’ve got to decide at the outset whether you’re ready to give control over to a vendor or if you really should keep it in-house. If you don’t resolve the issue of who’s in control, the type and quality of service you get from a vendor will be compromised. You might win the tug-of-war but lose the battle—and have to bring the outsourced project back in-house or find another vendor.

Problems have arisen when HR managers don’t honestly look at control and service issues from the start. Those who have been to hell and back with outsourcing say: First know what you do and how you do it internally. Decide how much control you want to maintain and at what level you want to maintain it. Setting up limits, deadlines and penalties in the contract will help you maintain control and keep service levels in check. But in the end, there are no guarantees.

Outsourcing is a two-way street. “Sometimes the failure isn’t with the vendor, it’s with the client,” urges The Segal Company’s Walsh, “especially when the client doesn’t have a clear vision of what its expectations are.” Just like employee relationships, if you don’t start with a clear job description, you can’t rate workers adequately—or at all. Know your vision, know your vendor’s vision and work out the details upfront.

Things can certainly go wrong—even if you hope for the best and plan for the worst—but at least you’ll be prepared for a disaster when you see one coming.

Workforce, September 1998, Vol. 77, No. 9, pp. 42-48.