A Medicare Reform Proposal Everyone Can Love: Finding Common Ground among Medicare Reformers

Studies | Health

No. 306
Saturday, December 01, 2007
by Andrew J. Rettenmaier and Thomas R. Saving


Features of the Medicare Reform

The centerpiece of the reform is the creation of Health Insurance Retirement Accounts (HIRAs) in which individuals put aside funds during their working years to partially prepay their retirement health care expenses.

“Health Insurance Retirement Accounts (HIRAs) would allow workers to save for their retirement health care expenses.”

Deposits to HIRAs.   All workers will have the same fixed percentage deducted from their paycheck, just as they now do with the current Medicare (HI) payroll taxes.  These deductions, however, will be deposited in an individual's HIRA, rather than going to the general revenue coffers of the federal government.  Further, since these deposits (just like current Medicare payroll taxes) will be subject to income taxation, HIRA are funded with after-tax dollars.  This means that the use of the funds during in retirement will be tax free, similar to withdrawals from a Roth IRA (Individual Retirement Account). 5

Contributions to the individual HIRAs will be deposited with private sector insurance/annuity providers who will be responsible for investing the funds.  Although HIRAs are nominally the property of the individual account-holders, they will not have access to these funds unless they reach age 65.  Just as with current Medicare, the receipt of any benefits from a HIRA is contingent on surviving to the age of eligibility.  HIRAs, therefore, should be thought of as insurance that is payable only if the worker lives long enough.  HIRAs are not part of a person's estate any more than current Medicare is part of anyone's estate. 6

Restructured Medicare Insurance. At the outset of the reform, Medicare Parts A, B and D will be combined into a single insurance plan, similar to current Medicare Part C (Medicare Advantage). Every individual will face a base deductible, or defined cost-sharing requirement, that will be indexed to grow at the same rate as overall per capita Medicare spending.  The base deductible, and the cost sharing it requires, would apply immediately upon adoption of the reform to all current beneficiaries, even though they have no HIRA balance. The initial base deductible used in the projections for this study is $2,500, which is in the neighborhood of a senior's current combined average spending for an individually purchased medigap policy and on out-of-pocket Medicare expenses.  Current beneficiaries would continue to pay their share of Medicare expenses through premium payments, but their cost sharing would be limited to the indexed base amount.7 7

“Workers would contribute 4 percent of their total earnings to their individual HIRAs.”

For future beneficiaries, each individual's total Medicare cost sharing will equal the base deductible plus the amount of the annuity from that individual's HIRA.  All retirees born in the same year, regardless of income, will face the same indexed base deductible.  The additional cost sharing requirement will depend on the annuity made possible by the individual's HIRA, which is in turn based on the beneficiary's preretirement income.  Thus, while the base deductible is not income related total deductibles rise with income since the level of HIRA annuity funding rises with income.

The exceptions are low-income participants.  Each year the federal government will make additional contributions to their Health Savings Account ( HSA) or similar health spending account to cover part of the deductible.  In many cases, the low income retirees' remaining cost sharing, after the government contribution, will be covered by HSA funds they roll over from year to year.  Retirees who receive government contributions could be required to roll over any remaining contribution until the base deductible is covered.  Once this requirement is satisfied they would be free to spend any remaining funds in their accounts.  [See the sidebar on “Benefits and Incentives for Low-Income Workers.”]

HIRA Contribution Rate.  It is assumed that all workers age 64 and younger in 2007 make contributions of 4 percent of their total earnings to these HIRA accounts in addition to the taxes necessary to pay benefits to current retirees.  Thus, HIRA contributions will reduce workers' take-home pay. 8

While additional contributions of 4 percent may seem burdensome on current workers, they must be considered in light of the alternative means of financing Medicare in the long run.  The authors previously estimated that an immediate payroll-tax increase to 17.5 percent would be necessary to fund all parts of the current Medicare program indefinitely using Trust Fund accounting. 9 Considering the growing burden of Medicare Parts B and D on federal revenue in addition to the tax rate increases that would be necessary just for Medicare Part A solvency, the 4 percent HIRA contribution rate is not unreasonable.

Rate of Return on HIRAs. The accumulation phase is the build-up of the funds in HIRAs before workers retire.  The decumulation phase is the period after retirement, when beneficiaries begin using their HIRA annuities for health care spending.  The initial estimates assume that HIRA balances will earn a 2.9 percent real rate of return (which is roughly the return paid on federal government bonds) during both the accumulation and decumulation phases. 10 Because there is much debate over the appropriate rate to use in evaluating Social Security and Medicare reforms that involve investments in private bonds and equities, a second set of projections uses a 5.2 percent rate of return during the accumulation phase — which is closer to returns in the private capital market.

Benefits and Incentives for Low-Income Workers

How will very low-income individuals afford even the base deductible? Before considering the solution to that problem, consider three questions that any reform must deal with if it is to succeed in dealing with Medicare's funding problems:

  1. Does the plan give Medicare patients the incentive to choose between health care and other uses of money?
  2. Does the plan give providers of care the incentive to compete based on price and/or quality of care?
  3. Does the plan allow Medicare patients to have the same access to doctors, hospitals, clinics and so forth that non-Medicare patients have?

If the base deductible were waived for low-income Medicare recipients, the answer to the first question would definitely be “no.” If low-income patients face no out-of-pocket costs, the answer to the second question would also be “no,” since providers would not compete for them on the basis of price. Further, if doctors' time is rationed by waiting rather than by price, the answer is most probably “no” to the third question as well. An effective reform must encourage all users to participate in the same system. The more that low-income individuals view their spending as using their own money, the more likely they are to have the same access to providers as other patients.

To make Medicare participants care about cost using significant deductibles while ensuring that health care is affordable and accessible to those with low incomes, the government would make deposits to the HSAs of low-income participants (adding to their annual annuity payment) to cover a large part of their deductibles. Specifically, their out-of-pocket cost sharing would be limited so that they never face higher out-of-pocket costs as a percentage of their Social Security benefits than do retirees who had medium earnings. In this way low-income participants would have the income to buy needed health care. Yet, they will treat these funds as any other source of income since the money, if not spent on health care, is theirs to spend on other goods and services.

Annuities and Spending Funded from HIRAs. Once people reach the eligibility age, their HIRA balances will be used to purchase annuities that will deposit a fixed sum into their HSAs every year for the rest of their lives.  For example, the day after their 65th birthday they will receive their first full-year payment.  The payment will be deposited in their HSA and can be spent on health care during the coming year.  Individuals are free to spend any annuity amounts remaining at the end of each year on other consumption, without penalty, or they can roll the balances over for use in the following years (to cover the base deductibles, for example).  As a result, the annuity payment is equivalent to other after-tax income.  If a senior dies during the year, any balance remaining in the HSA is part of their estate.

“HIRAs will fund annuities retirees can spend on health care each year, and they can use unspent funds for other consumption.”

Incentives under the Reformed System.  The proposed reform is based on high-deductible insurance and greater retiree command over health care dollars.  It produces better incentives for both demanders (patients) and suppliers (providers) of health care.  Further, this design makes reformed Medicare more like true insurance, in stark contrast to the first-dollar coverage that is prevalent in the health care market today.  Because patient cost sharing expenses will be met with after-tax dollars, health care will compete with other consumption choices on a level playing field.  As a result, patients themselves will be choosing between health care and other uses of money instead of the bureaucratic rationing of health care that sometimes occurs in other countries.

All the evidence suggests that individuals who have higher deductibles spend less on health care, often with no detriment to health outcomes.  Higher deductibles may also reduce the growth rate of health care spending.  Note that the higher deductibles generated by higher earnings (and therefore higher HIRA deposits) do not impose a financial burden in retirement on the individual because they are covered dollar-for-dollar by higher annuity payments.

The estimates of the effect of higher deductibles on health care spending are based on the results of the RAND Health Insurance Experiment of the late 1970s.  The experiment tracked the behavior of patients facing different health insurance cost-sharing arrangements.  Even though the experiment did not include elderly individuals, its findings provide the best evidence of the effects of cost-sharing on health care spending and utilization of services.  The RAND results are used to identify the upper and lower bounds of a range of effects on health care spending that may result from the proposed reforms. 11 [See the sidebar below on “Effects of Deductibles on Health Care Spending.”]

Other Insurance Options.  The high-deductible insurance plan is a point of reference.  It helps identify the government's obligation (expected expenses above the deductible) in each and every year.  However, once the government (taxpayer) obligation has been determined, other insurance arrangements are possible.  Specifically, Medicare could pay a risk-adjusted premium on behalf of the beneficiary to an HMO, to a plan with flexible deductibles (high for some services and low for others) or to some other plan.  Medicare's payment to a potential insurer would be identified as the expected spending above the retiree's total deductible given his or her health status.  The senior could add to the government's premium payment with a payment from his HSA, if needed.  This flexibility would allow the marketplace to discover new and better ways of meeting seniors' insurance and health care needs.

“Higher income workers with larger annuities will face higher total deductibles.”

Distributional Effects of the Reform.  The reform plan treats beneficiaries with different lifetime earnings differently in terms of the insurance package they receive.  By contrast, the current Medicare system treats low- and high-income retirees the same in many respects. 12 Both groups face the same deductibles and copays for Medicare Parts A, B and D.  They also have identical Medicare premiums of $93.50 per month for Part B deducted directly from their Social Security checks (as long as their annual incomes are less than $80,000 for individuals or $160,00 for a couple). 13 If they choose the same Part D policy, the premiums are identical across income classes and are also deducted directly from their Social Security checks.  However, to fund Part A, Medicare collects payroll taxes that are proportional to income and uses other taxes (primarily income taxes paid by higher income workers) to fund some spending on Parts B and D.

The accumulated value of high-income workers' payroll taxes in support of Medicare Part A combined with their income taxes in support of Medicare Parts B and D are substantially greater than the similar accumulated value of low-income workers' tax payments.  Over a lifetime, high income retirees will pay more taxes than lower income retirees, but they will receive an insurance benefit package with identical coverage.

By contrast, under the HIRA reform higher income workers will receive higher annuity payments from their HIRA account accumulations and face higher total deductibles.  As a consequence, they will pay for more of their health care during retirement than lower income workers.  Retirees who have low lifetime earnings will have lower annuities and consequently lower total deductibles.

Viewed over a lifetime, the HIRA reform is similar to the present program in terms of within-generation redistribution through the program's funding.  However, the HIRA reform makes the current within-generation financing arrangement explicit.  And the differential impact of the total deductibles that rise with income will produce quite different incentive effects than the uniform deductibles and copays under the current structure.

“Each generation of workers will save to pay some of their retirement health care costs.”

Effects on Generational Equity.  Medicare's current pay-as-you-go financing arrangement effectively transfers the costs of the program to the next generation of taxpayers.  Further, given the surge in retirees relative to workers that will occur as a result of the retirement of the baby boomers and the projected increase in health care consumption by the retired population, future taxpayers will have to bear the cost of a growing program.

The reform proposal addresses Medicare's generational inequity by having members of each generation of workers pay more of the cost of their own health care through partial prepayment.  This reduces the burden on the next generation by having current workers fund more of the burden of their own benefits through their HIRAs. It also reduces the burden on the next generation by changing the health care consumption incentives of retirees, as upfront deductibles make retirees at every income level more cost conscious.

Why should the current generation take on this challenge?  Simply put, a structural reform at this time may be in its best interest.  Absent reform, budgetary pressures may force politicians to reduce projected benefits for future retirees.  But those future retirees are the workers of today.  Partial prepayment is also partial insurance against what many consider the inevitability of future benefit reductions.


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