Saving Medicare
The Cost of Prefunded Insurance
"Individuals who die between ages 65 and 70 have lower health care costs than those who die later."
15How large would the deposits have to be in order for each new cohort to fund its postretirement health care expenses? Table II shows the required contributions, expressed as an annual deposit and as a percent of life-cycle earnings income, that an average new labor force entrant would face until age 65. The required contribution varies with assumptions about the rate of return on investments, the growth rate in medical expenditures and the cost of the prefunded benefits.16 Let's consider each of these assumptions in turn.
Rate of Return for PRIME Accounts. Provided that PRIME account funds were invested professionally and conservatively in a diversified portfolio, what rate of return would we expect? Poterba and Samwick calculated that for the years 1947 through 1995 the nonfinancial corporate sector paid a real pretax rate of return of 9.2 percent.17 Feldstein and Samwick estimate that a portfolio of 60 percent equity and 40 percent debt would have yielded a real pretax return of about 5.5 percent over both the postwar period and the period since 1926.18 They also suggest that if corporate taxes at all levels take 40 percent of pretax debt and equity income, a 5.4 percent after (corporate) tax return is equivalent to a 9 percent pretax return.
In making the calculations in Table II, we estimated the amount of annual deposit required based on four different rate of return assumptions: a conservative 3.5 percent rate, the after-tax 5.4 percent rate and the pretax 9 percent rate for a balanced portfolio, plus a 6.4 percent rate for a 100 percent equity portfolio - reflecting the real rate of return between 1926 and 1995 based on the Standard & Poor's 500 Index including dividend reinvestment.
"Under reasonable assumptions, young people entering the labor market today would need to deposit about $500 a year."
Rate of Growth of Health Care Costs. Because the actual growth in retirement health care expenditures is unknown, we estimate the required deposit using three different assumptions about the real growth rate of per capita medical care expenditures: 0, 1, and 2 percent. By way of comparison, the Medicare trustees in 1997 assumed that Medicare's real cost per unit of service will grow at a rate of about 3 percent during the first 10 years of the forecast, gradually decline to about 1.7 percent by the 25th year and drop to a growth rate equal to the growth rate in real wages in all remaining years.
Cost of Health Insurance at Today's Prices. The table also presents estimates of the required deposit based on estimates of the cost of postretirement health insurance at today's prices, assuming that people choose the current Medicare package, a high-deductible ($2,500) package under low-cost assumptions or a high-deductible package under high-cost assumptions.19
Results. The contribution rate for entering cohorts ranges from a low of $67 per year to a high of $2,132, based on the differing cost and growth rate assumptions. Under a reasonable investment strategy, the required contribution is well below Medicare's total expenditures on health care for the elderly (net of premium payments), which equaled 4.39 percent of taxable payroll in 1996. Thus if government continues to impose the 4.39 percent tax, it is possible for new entrants to fund their retirement medical care, with some of the tax money left over to fund the cost of the transition. For example, as Figure VI shows:
- Assuming 1 percent real growth in medical expenditures, a worker whose PRIME account funds were invested in equities could replace Medicare for an annual contribution of only $395.
- A worker whose funds were invested in a balanced portfolio could replace Medicare for an annual contribution of $582.
- These amounts are well below the $1,120 tax that Medicare is expected to collect from the average worker over the same time period.
One way to think about these results is to consider that private pension funds often invest in equities for most of a worker's career and then shift to bonds in the last 10 or so years to protect against market fluctuations on the eve of the individual's retirement. Following that strategy, under these assumptions, a worker would have to deposit about $500 - less than half the expected Medicare tax.
Even if medical expenditures grow at the faster rate of 2 percent per year in real terms, the private option is more attractive for workers. The required deposit, which ranges between $676 and $1,005 depending on the investment strategy, is still less than Medicare is expected to extract under the current system.
Figure VII shows how the deposits will grow over time if invested in a balanced portfolio. As the figure shows, an annual investment of $582 will grow to more than $90,000 in 1997 prices - and more than $180,000 for a married couple - by age 65. This should be sufficient to replace Medicare with comparable private health insurance. As an alternative, people may prefer high-deductible, catastrophic insurance - managing their own health care dollars for smaller expenses. As Figure VII shows, an individual who saved for Medicare replacement would accumulate as much as $20,000 - $40,000 for a couple - to place in a Medical Savings Account to pay medical bills under $2,500 a year, long-term care expenses and other items not covered by Medicare.
"Older workers would make larger contributions."
Figure VIII shows how the required contribution to PRIME accounts varies for people of different ages at the time the plan is instituted. As the figure shows, older workers would make larger contributions. Still, under reasonable assumptions a worker earning the average wage could prefund his or her postretirement health care with PRIME account contributions less than expected Medicare taxes out to about age 40.
