December 2006

Fixing Medicare: An Intergenerational Dilemma

By George McClure

For its future unfunded costs, Medicare is the 800-pound gorilla in the room that people ignore when looking at the smaller problem of future funding for Social Security. The aging of our population, as birth rates decline and life expectancy increases, is the most significant demographic force that will shape our economy and society in the coming decades, as Federal Reserve Chair Ben Bernanke noted in October. [www.federalreserve.gov/boardDocs/speeches/2006/20061004/default.htm]

How well we deal with the funding issue will affect the extent to which we push costs forward to future generations. Saving more now can reduce their future burden.

Future Uncertainty

Former Fed Chair Alan Greenspan noted in 2005 that most of the benefits recipients in 2030 have already been born. "Thus, forecasting the number of Social Security and Medicare beneficiaries is fairly straightforward. So, too, is projecting future Social Security benefits, which are tied to the wage histories of retirees. However, the uncertainty about future medical spending is daunting. We know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending. Consequently, the range of possible outcomes for spending per Medicare beneficiary expands dramatically as we move into the next decade and beyond. Technological innovations can greatly improve the quality of medical care and can, in some instances, reduce the costs of existing treatments. But because technology expands the set of treatment possibilities, it also has the potential to add to overall spending — in some cases, by a great deal. Other sources of uncertainty (e.g., the extent to which longer life expectancies among the elderly will affect medical spending) may also turn out to be important. As a result, the range of future possible outlays per recipient is extremely wide. The actuaries' projections of Medicare costs are, per force, highly provisional." [www.federalreserve.gov/BoardDocs/testimony/2005/20050421/]

Program Details

Three-quarters of Medicare costs are covered by the program, with one quarter paid by the recipients. Medicare serves seniors age 65 and older as well as younger disabled. Since the program was enacted in 1965, demographics have changed, with a larger share of the population becoming eligible for Medicare services.

From the outset, the program had three parts, with three trust funds: Part A, for hospital services, and Part B, for physician services (major medical). A Disability Insurance (DI) fund is separate and covers those receiving Social Security disability income. A Medicare managed-care program was added as Medicare Part C, now called Medicare Advantage. To these, Part D — the prescription drug program — was added in 2004. Enrollment in Part A is automatic, but Parts B and D are voluntary and separate premiums are charged for them. With the advent of the drug program, Parts B and D have been combined under the Supplementary Medical Insurance (SMI) trust fund.

Medicare functions as an insurer, in tandem with other medical insurance to take up the slack. Participants can choose from and purchase tailored Medicare supplementary insurance policies, called Medigap, to offset some of the costs that Medicare does not cover.

Originally designed as a fee-for-service program, with the insureds enjoying a wide selection of providers who accept Medicare patients, over time, various alternatives have been offered to "traditional" Medicare. These include HMO- and PPO-type services contracted and paid by Medicare. While the choice of providers is restricted, many offer additional benefits, such as prescription drug coverage plans. Launched as Medicare + Choice, that part of the program is now called Medicare Advantage.

Seventy-five Year Assessment

The Social Security and Medicare Trustees, who evaluate the programs and report annually, note in their 2006 report that both the Social Security and Medicare programs are not financially sustainable in their present form, given the expected growth in numbers of recipients. [www.socialsecurity.gov/OACT/TRSUM/trsummary.html] The HI hospital insurance fund is projected to run out of money by 2018, and Social Security's funds will be exhausted by 2040.

Steps to Strengthen Social Security

The Social Security problem, involving only calculated benefits and demographics, is easier to solve than Medicare's, which is compounded by rising health care costs, advancing technology and an aging population. While politically difficult, stepping up the contributions and easing back on the benefits could make Social Security whole again.

The payroll tax for Medicare is not capped, but the payroll tax (FICA) for Social Security has a salary cap above which there is no contribution. Below that level, the employer and worker contribute 6.2 percent each. Currently, this cap is set at $94,200, with future increases indexed for inflation. Removing the cap would increase receipts and avert the deficit now projected to begin in 2017, when the system will start paying out more than it takes in. Other options could involve a lower, graduated, tax rate above the present cap, or a raised (not totally removed) cap.

The 1983 bipartisan commission on Social Security recommended changes, including a gradual increase in retirement age (to draw full benefits) to age 67, for those born after 1959. Raising the age immediately to 67 for all future retirees, and to 70 for healthy workers would also be helpful.

Reducing future growth in benefits could also help balance the books. Benefits are subject to annual increases based on average increases in workers' pay. Tying it instead to the lower consumer price index (CPI) would help reduce the outflow. It has been argued that, since most retirees own their homes, the housing component in the CPI may overstate their real cost-of-living growth.

For more details see [www.actuary.org/pdf/socialsecurity/trustees_may06.pdf]

To try your hand at a ‘fix', see the interactive menus at [http://www.actuary.org/socsec.asp]

Prescription Drugs — the Newest Entitlement

The Medicare Modernization Act of 2003 established Medicare Part D, adding prescription drug coverage to the program, but included a prohibition against negotiating drug prices directly with drug companies, even though the government, including the Veteran's Administration (which does negotiate prices) has a market share of about 46 percent. This practice may change with the shift in control of Congress.

[www.actuary.org/pdf/medicare/trustees_may06.pdf]

The Medicare prescription drug plan, approved by five votes (220 to 215) in the House in 2003, took full effect in January 2006. After an initial $250 deductible, it covers three-quarters of the next $2,250 in drug expense. For the next $2,850 in drug expense, there is no coverage, but at $5,100 coverage resumes, for 95 percent of covered prescription drug expense. The so-called "doughnut hole" was inserted in the coverage to contain the program cost, promoted as limited to $400 billion in 10 years. After the bill was signed into law, the cost estimate had risen to $534 billion over 10 years. Later estimates ranged as high as $1.2 trillion. [www.washingtonpost.com/wp-dyn/articles/A9328-2005Feb8.html and www.whitehouse.gov/news/releases/2005/02/20050209-13.html] The annual cost of the Medicare drug program is estimated at $107 billion by 2014, covering some 41 million seniors.

As enacted, the Medicare Part D program prohibited competition for best price, and did not allow importation of drugs from outside the United States, based on the rationale that competing to drive down drug prices would reduce funds available for drug companies to devote to R&D to develop newer drugs, and importation that would open the way to counterfeit drugs.

Murky Outlook for Medicare

So, what is the long-term unfunded liability for Medicare? In 2005, it was projected as $29.7 trillion.

This year, the Government Accountability Office (GAO) issued a report on its modeling of both Medicare and Social Security. According to GAO, if benefits are not cut and revenues are not increased, the 75-year liability could total $61 trillion in today's dollars — 8 percent of the economy. [www.gao.gov/new.items/d061077r.pdf]

What Can Be Done?

Bernanke advocates a higher savings rate for the United States, which would imply a reduction in the federal government's deficit spending. As the aging population remains healthy and active, continuing participation in the work force — and delaying full retirement — become an option for some.

Each program has only two choices, if general government indebtedness is not to rise precipitously: Cut benefits or raise premiums.

Critics point out that there is no means testing for either Social Security or Medicare benefits, but that upper-income retirees who have comfortable nest eggs or pensions can afford to have their benefits cut. The counter argument is that saving for retirement will be discouraged if it becomes known that successful savers are penalized with reduced government benefits, while lower-income retirees are not. Critics of means testing argue that it would change both programs from an entitlement to a welfare program. The AARP, which lobbied for the Medicare drug program, favors covering shortfalls, to the extent possible, by use of progressive income taxes that generate general revenue funding, rather than other options that would disproportionately affect a narrower group (e.g., current beneficiaries, current workers/future beneficiaries, providers, states). [www.aarp.org/research/medicare/financing/aresearch-import-874-IB67.html]

Based on the 2004 intermediate projections for 75 years, the Concord Coalition found that payroll taxes would have to rise 288 percent, to 44 percent of income, by 2075 to keep both programs solvent without reducing benefits — which is clearly not possible. [www.concordcoalition.org/issues/socsec/issue-briefs/SSBrief3--1Percent.htm]

Personal Savings Accounts — Dead on Arrival?

Even the more tractable problems of Social Security funding alone cause debate. Carving Personal Savings Accounts (PSAs) out of some of the Social Security payroll tax contributions was viewed with suspicion — even after the president spent a month last year talking up the idea in town meetings across the land (although no specific proposal was ever on the table). Critics called the private accounts a windfall for Wall Street in management fees. Supporters said the fees would be minimal, with low-fee index funds as a model for account investments, and that earnings would be at a higher rate than for the Social Security Trust Fund. Part of the problem was lack of immediacy for the insolvency. An attendee at one of those sessions, interviewed afterward for her opinion, said "If it ain't broke, why fix it?"

Speculation now is that the personal accounts proposal may be abandoned in favor of a bipartisan solution with the new Democratic-controlled Congress.

Future Uncertainty

In 2004, Alan Greenspan warned: "This uncertainty is an important reason to be cautious — especially given that government programs, whether for spending or for tax preferences, are easy to initiate but can be extraordinarily difficult to shut down once constituencies for them develop." [www.federalreserve.gov/boarddocs/testimony/2004/20040225/]

Productivity Increases Help

Productivity increases over the past decade have been key in driving improvements in Gross Domestic Product (GDP) faster than increases in employment. Some of those improvements have aided in efficient delivery of medical care, but slower growth in payrolls has also impacted the tax collections for Medicare and Social Security.

Arguments for higher payroll taxes (the Medicare tax now applies to all income earned in the United States, while the Federal Insurance Contributions Act, or FICA, tax for Social Security is capped at $94,200 for 2006 and $97,500 in 2007) are countered with concerns that reducing after-tax wage income through higher payroll taxes can reduce incentives to earn still more income.

As the Concord Coalition points out, "Currently all beneficiaries pay only 25 percent of Part B program costs; the remainder comes from general revenues. The basic issue is one of fairness. It makes no sense for a working couple with two children, and a $50,000 income (about the national median for family households) — trying to buy a home, trying to find affordable health insurance, trying to save for their kids' education, and trying to put aside something for retirement — to have to pay 75 percent of the Medicare premium for a retired couple whose income exceeds $150,000 a year (far above the national median.)"

"Raising the SMI premium, which is nothing more than a reduction in the government subsidy for upper income beneficiaries, is among the easiest of the hard choices," said Concord Coalition Executive Director Robert Bixby. [www.concordcoalition.org/press/2003/030626release.htm]

More than a decade ago, Peter G. Peterson, a former Secretary of Commerce and now president of the Concord Coalition, offered a prescription in his book, Facing Up: Paying Our Nation's Debt and Saving Our Children's Future. He recommended adjusting entitlement benefits on a sliding scale depending on income, above $35,000 (about $48,000 today); making all benefits fully taxable; increasing taxes on the very wealthy; and encouraging the use of managed care with higher consumer co-payments to discourage overuse. As with any proposal for change, the devil is in the details, and changes would have to be advertised well in advance, so that recipients, especially retirees, will have time to adjust.

One Step Forward

One small step was to increase the Supplemental Medical Insurance (SMI – Part B) premium for upper income beneficiaries, effective in 2007. This idea has been around since at least 1983. [www.cbo.gov/ftpdocs/50xx/doc5036/doc29.pdf]

Applying to taxpayers with incomes above $80,000 ($160,000 if married), the increase affects only about 4 percent of Medicare recipients. The highest 1 percent of recipient taxpayers (income above $200,000, or $400,000, if married) will pay a monthly $161.40 premium, compared to the normal $93.50 (up from $88.50 in 2006). These limits will reduce Medicare costs by an estimated $7.7 billion over the next five years and $20.8 billion over the next 10 years. [www.cms.hhs.gov/apps/media/press/release.asp?Counter=1958]

One Step Back

Contrary to Greenspan's advice not to add more entitlement programs, Medicare Part D was enacted.

GAO Weighs In

The GAO, characterizing our present fiscal path as unsustainable, points to several tax preferences as part of the problem, including, for 2007:

• $177.6 billion employer contribution exclusion for employee insurance premiums and medical care (including pre-tax treatment for employer payroll tax contributions);

• $62.2 billion deductibility of mortgage interest on owner-occupied dwellings;

• $50.6 billion exclusion for contributions to defined benefit pension plans;

• $37.4 billion exclusion for contributions to 401(k) plans.
  (See slide 15 at http://www.gao.gov/cghome/d061078cg.pdf)

Avoiding Intergenerational Conflict

Bernanke reports on studies of consumption and savings rate changes that would equalize the shared burden of population aging across generations.

"Board economists first examined the case in which the nation saves at its current rate for the next 20 years, thereby largely insulating the baby-boom generation from the effects of the coming demographic transition. After that, they assumed, consumption falls and saving rates rise, with all future generations experiencing the same percentage reduction in consumption relative to the baseline in which no population aging occurs. Their rough calculations suggest that, in this case, the per capita consumption of future generations would be about 14 percent less than what it would have been in the absence of demographic change.

"For comparison, they next considered the case in which the burden of demographic change is shared more equally among current and future generations. They considered a case in which the national saving rate, instead of staying at its current level for the next 20 years, rises immediately. Further, they asked by how much today's saving rate would have to increase to lead to equal burden-sharing among current and future generations. ("Equal burden-sharing" is interpreted to mean that the current generation and all future generations experience the same percentage reduction in per capita consumption relative to the baseline scenario without population aging.) They found that equal burden-sharing across generations could be achieved by an immediate reduction in per capita consumption, on the order of 4 percent (or, since consumption is about two-thirds of output, by an increase in national saving of about 3 percentage points.)

"Perhaps the most straightforward way to raise national saving — although not a politically easy one — is to reduce the government's current and projected budget deficits. To the extent that reduced government borrowing allows more private saving to be used for capital formation or to acquire foreign assets, future U.S. output and income will be enhanced and the future burdens associated with demographic change will be smaller."
[www.federalreserve.gov/boardDocs/speeches/2006/20061004/]

A 4 percent decrease in consumption will not be easy for a nation that has spent its entire income in recent quarters, and has even ventured into negative personal saving rates as equity gains from the run-up in the housing market were spent. For more on national saving, see [www.federalreserve.gov/boardDocs/speeches/2005/20050302/]

Obstacles to be overcome include not only unplanned deficits associated with the Iraq war and hurricane restoration, but also the desire to eliminate the Alternative Minimum Tax (AMT) for individuals (requiring alternative funding sources for the $1.3 trillion tax revenue (over 10 years) that would be lost).

The Congressional Budget Office offers its own projections showing the growth of entitlement programs as the population ages. See [www.cbo.gov/ftpdocs/70xx/doc7027/01-26-BudgetOutlook.pdf]  pp. 155-157 for the forecasts to 2016, when Social Security, Medicare, and Medicaid will account for 56 percent of all federal spending (10.8 percent of GDP), up from 43 percent in 2006 (pp. 15-16). Just indexing the AMT for inflation would reduce tax revenues by $544 billion between 2007 and 2016, according to the CBO (ibid., p. 36).

The earlier that actions are taken to avert the looming crisis, the easier those actions will be. But the politics are daunting.

George McClure is chair of IEEE-USA's Communications Committee, a member of the IEEE-USA Career and Workforce Policy Committee, and technology policy editor for IEEE-USA Today's Engineer. Comments may be submitted to todaysengineer@ieee.org.