A Framework for Medicare Reform

Policy Reports | Health

No. 315
Friday, September 12, 2008
by John C. Goodman

Comparison with a Private, Voluntary Plan

How does the plan outlined above differ from what might arise in a free market agreement among voluntary, consenting individuals?

Purely Private, Contractual Relationships. Imagine a large number of 20-year-olds, contemplating their future. They would like to make sure they will have access to health care during the years of their retirement. But how can they secure this objective? Ideally, each would save a certain percent of his income over the course of his worklife and use the accumulated savings to purchase health care and health insurance during the retirement years.

The problem: No individual can reasonably predict what his life cycle income will look like, what his health status (and therefore health costs) will be at age 65 or how long he will even be alive. Fortunately, predicting for the group as a whole (or what is almost the same thing: predicting what will happen to the average person) is much easier than predicting for a single individual. And even though no one can reliably predict what will happen to the average person over 45 years, we can always begin with an estimate and readjust every 5 or 10 years (raising or lowering the needed contribution rate) as experience dictates.

This is where insurance comes in. An individual acting alone faces the risk that his own experience will deviate from the average — possibly doing much better, possibly doing much worse. The downside risk is that the individual will reach the retirement years with too little to pay for his needed health costs. It is precisely this risk that people, in principle, could insure against. Ideally, a voluntary insurance contract would insure the individual against (a) unexpected changes in income, (b) unexpected changes in health status and (c) nonaverage mortality. There is no reason in principle why this relationship could not be voluntary, consensual and completely private.

It may also be possible to protect individuals against the risk of market volatility. For example, the day an individual reaches age 65, the market may be high or it may be low. However, a smoothing of returns over cohorts spanning, say, 5 to 10 years may provide insulation against wide swings in investment returns.34

A Mandatory System. Like the current Medicare program, the reformed system we propose would be mandatory. However, it would be much closer to a completely private system than what we have today.

Why does participation have to be mandatory? It doesn’t. And it shouldn’t if we are willing to allow people to live with the consequences of their own decisions and their own bad luck. However, there is no evidence of any such willingness. As a practical matter, society is going to provide substantial health care to people in their twilight years, even if they have negligently and willfully saved not a penny for their own post-retirement health care needs. Thus without mandated savings, individuals could game the system — consuming all of their income during the preretirement years and relying on the charity of others during retirement.

In this sense, the argument for forced savings for post-retirement health care is similar to the argument for forced savings for (Social Security) retirement income. It basically ensures that individuals pay their own way and precludes opportunities to exploit the generosity of other members of their cohort.

Harder to defend is the practice of charging everyone the same percent of income (same payroll tax) to enter the pool. Surely, a private insurer would not treat all 20-year-olds the same, even though the payout is 45 years down the road. Although we discussed above the higher burden on higher-income enrollees, the current structure of Medicare is far less redistributive than one might suppose. Although low-income people pay fewer dollars into the system over their worklives, they die earlier, and after age 65 they consume less health care than higher income retirees.35

A Reformed Medicare System. There are two primary sources of funds to pay for health care in a reformed Medicare system: accumulations in HIRA accounts and money that flows through government. We envision that HIRA funds will be managed by private sector trusts, that the relationship of the trusts to the beneficiaries will be contractual and that an individual’s property rights in these funds will enjoy the full protection of due process of law. Although these trusts will be subject to government-imposed rules requiring safe and prudent management, the government will not be able to seize the funds any more than it can seize the funds in someone’s IRA.

As noted, during the accumulation phase of an individual’s life, his right to his HIRA contributions is contingent on survival to age 65. For those who do not survive, the HIRA balance remains in the private sector and is redistributed to the remaining members of the insurance pool. During the decumulation (retirement) phase, individuals have contingent rights to their annual annuity payments or programmed withdrawals.

As long as government funds are used to complete the process of risk adjustment, individuals may be said to have a direct property right in their HIRA annuities. However, as HIRA balances grow relative to taxpayer commitments, HIRA annuities themselves will be subject to an insurance arrangement. Specifically, individuals will have a property right to a risk-adjusted annual payment, based on the worklife contributions they and their cohorts make. This annual payment will be adjusted for four types of risk: (1) income volatility, (2) changes in health status, (3) mortality and (4) market volatility.36

Some may question whether the property right to a risk-adjusted annual payment is as valuable or desirable as the right to the exact dollars an individual contributes over a worklife. In fact, the former is more valuable than the latter. The reason: the former provides insurance protection that is worth more than it costs.

In contrast to the contingent-insurance property right individuals will have with their HIRA funds, they will have no legally enforceable right to the funds that come from government. Although under our proposal the government’s objective is to ensure that every retiree has access to an affordable SCP plan, this is not a contractual commitment any more than the current Medicare system makes contractual commitments to provide future health care to beneficiaries. As federal court rulings have affirmed for Social Security, a current Congress cannot bind future Congresses. As the need for change arises, we expect that government can and will change its policies.

It may seem that risk-adjusted payments on behalf of retirees discriminate against people who adopt healthier lifestyles and thereby encourage unhealthy behavior. While this may be true of spending in any given year, a new study finds that over a lifetime, people who adopt healthy lifestyles actually spend more health care dollars than obese people and those who smoke.37 As a result, people with healthy behaviors may gain from a system of risk-adjusted payments during their senior years. Healthier retirees also gain by being more likely to be able to use their unspent HSA balances for nonhealth purposes.

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