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Saving Medicare
January 1999
Design, Timing and Pricing Issues
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"At retirement, people could choose among competing health plans." "One question to be resolved: at what age should an insurer be selected." "Many problems would disappear if people had to choose a plan and remain in it for at least three or four years."
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The prefunding of care will insure that future taxpayers are not responsible for the medical care expenses of retirees. As each age group retires, enough funds will have been accumulated to cover that group's total insured expenditures. Given that we have potentially solved the funding problem, however, a host of other questions remain. What type of health insurance should people be permitted (required) to buy? When should they be permitted to buy it? What premium should insurers be able to charge? What should be the duration of the insurance contract? How frequently should people be able to switch health plans?
These questions do not uniquely stem from the reform plan we are proposing. The same questions must be addressed under the current structure of Medicare. And the answers imbedded in the current system are not necessarily the best answers.
Health Insurance Options.
Until recently, all beneficiaries under Medicare had essentially the same insurance coverage. For reasons discussed above, the design of Medicare is quite inefficient and private insurers surely could improve on it. The first ones given the opportunity to create an alternative were certain Health Maintenance Organizations (HMOs). Most seniors now have the option to join an HMO with most or all of the premium paid by Medicare and about 13 percent have done so. Beginning in 1999 seniors will have other options, including private fee-for-service plans, Medical Savings Account (MSA) plans and physician-run plans.Since choices of this sort are already planned under the current Medicare system, it seems almost inevitable that they would also be a feature of any private, prefunded alternative. Choice has obvious potential benefits for the insured, giving them opportunities to select the most suitable plans. Encouraging insurers to find innovative new ways to meet consumer demand also can have benefits. But competition in health insurance can have drawbacks as well, especially when premiums are artificially constrained.
For example, under the current system HMOs receive the same Medicare payment, regardless of the expected health care costs of the enrollee, with some exceptions discussed below. This gives the HMOs a perverse incentive to avoid the sick, whose expected costs exceed the premium income they generate, and attract the healthy, whose premiums exceed their expected costs. Moreover, if people develop a health problem after they enroll, HMOs have an incentive to provide less than optimal care in an effort to encourage them to switch back to Medicare or to some other HMO. Whatever their resolutions, these problems must be confronted regardless of how Medicare is financed.
Timing Options. Given that people will be able to use their PRIME account funds to obtain insurance, at what age should they be able to exercise that option? Must they wait until they are 65? Or should they be able to select an insurer much earlier? (Note: even under the current system, people could be allowed to select a private insurer long before they reach age 65.)
Either approach has advantages and disadvantages. The main problem with early commitment is that neither the insured nor the insurer has important information that will be revealed years after the choice is made. On the consumer side, someone entering the labor market today at age 22 will not know how the health plans are going to function 43 years later - when the chooser will actually need the services. On the supplier side, insurers may be unwilling to commit so many years in advance. If they do commit, they may be unwilling to promise the same benefits that they would at a later date. The reasons are obvious: uncertainty over the cost of medical care and uncertainty over the performance of capital markets.
Early choice would help solve the problem of varying health care risks, however. For example, if people choose their insurer in the prefunded system at age 22, when they presumably know little about what their medical care needs will be at age 65 and beyond, then each insurance pool will tend to have a cross-section of individuals - some of whom will be sick and some of whom will be healthy by the time they all reach age 65. On the other hand, if individuals choose their insurer at age 65, when they know more about their medical care risks, problems of adverse selection are likely to arise.
The problems that arise if health plans are required to accept all applicants are addressed above. And if they can reject applicants with high expected health costs, different problems arise. In any health insurance pool, the lower risks in the group are subsidizing the higher risks. This creates an incentive for lower risks to move to another pool with lower average risks and lower premiums - an option not available to high-risk members. As the low risks leave, premiums must be increased to cover the now-higher costs of the remaining members. Higher premiums, in turn, encourage even more departures. The result is a "death spiral" in which the plan is left with only the most expensive enrollees - who cannot afford to pay premiums that cover the cost of their care.
Pricing Options. One way to avoid the death spiral described above is to allow insurers to charge premiums that reflect expected costs for everyone who joins the pool. Thus, sick people would be charged higher premiums and healthy people lower ones. Under the current system, HMOs are not allowed to charge different out-of-pocket premiums to enrollees, based on their health status. However, Medicare's payment to the HMOs does vary depending upon certain indicators of expected costs, and more such risk adjustment of premiums is expected in the future.13 A similar kind of risk adjustment could be forced on the private system envisioned here by requiring pools that disproportionately attract healthy people to make payments to pools that disproportionately attract sicker people.
Still, no risk adjustment scheme works very well. Based on objective factors alone, health economists can predict no better than about 25 percent of the variation in future health care costs among individuals.14 Part of the problem is that information is often asymmetric. Enrollees have knowledge about their own health neither insurers nor risk adjusters possess. Perversely, insurers can sometimes take advantage of this asymmetry by making their health plans less attractive to sick people and more attractive to healthy people. The more freedom the plans have to differentiate their product, the more opportunities they have to encourage the healthy and discourage the sick.
Thus pricing restrictions exacerbate the trade-off described above: the more choices people have, the greater the problems of adverse selection. One way out of this problem may be to require lengthier insurance contracts.
Length of the Contract Options. How long should anyone be required to stay in his or her chosen health plan before switching to another? Most employers who give employees choices tend to allow switching only once a year. Although the new Medicare program will permit switching at will initially (except for the Medicare MSAs), eventually it also will revert to an annual enrollment. But is a one-year contract the best option? An alternative would be to require people to choose a health plan at age 65 and remain in that plan for the rest of their lives. A long-term insurance contract would reduce the problem of adverse selection in several ways. For the reasons given above, the longer the time horizon, the less information anyone has about future health care costs, and people who are sick today are not necessarily the most expensive patients over the long haul, since people who die soon do not generate more costs 10 or 20 years down the road.
Thus under long-term contracts insurers face both health care risks and longevity risks. Figure V shows the present value of annual Medicare payments (as of age 65) for individuals who die at different ages, using three discount rates: 3 percent, 5 percent and 7 percent. As the figure shows, individuals who die between ages 65 and 70 have lower health care costs than those who die later.
The conclusion is that many problems associated with annual movement among plans would disappear if people had to choose a plan and remain in it for at least three or four years.
The Cost of Prefunded Insurance15
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"Individual who die between ages 65 and 70 have lower health care costs than those who die later." "The required contribution varies with assumptions." "Under reasonable assumptions, young people entering the labor market today would need to deposit about $500 a year." "The required contribution will be well below Medicare taxes paid by the average worker." "An annual investment of $582 will grow to more than $90,000." "Older workers would have to make larger contributions." |
How 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.
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.
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.
