Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 20 The Economics of Retirement and Healthcare

20-2 Chapter Objectives Basics of retirement Employer retirement plans Social Security Basics of healthcare spending Employer health insurance plans Medicare and Medicaid Rising cost of healthcare Policy response

20-3 Basics of Retirement Retirement means that someone no longer has income from work and must finance the level of spending. The life-cycle theory of retirement says people spend when they are young, save during the latter part of their working lives, and then spend while they are retired. –That is, they build up a nest egg and then spend it down.

20-4 Basic Financial Life Cycle Youth: Spend on education and buying a home Middle Age: Build up savings Old Age: Use savings for medical and living costs Age Net worth Peak earning years Retirement Borrowing for home and education

20-5 Problems with the Life-Cycle Theory Two things can go wrong with the life- cycle theory: –The retirement poverty problem occurs because poor people often cannot save much for retirement. –The retirement uncertainty problem occurs because individuals don’t know how long they will live.

20-6 Employer Retirement Plans Employer retirement plans are provisions for retirement that your employer contributes to on your behalf. There are two types of employer retirement plans: –First, a defined-benefit plan provides retirees a pre-determined amount of money monthly. This plan is funded by the employer.

20-7 Employer Retirement Plans –Defined-contribution plans require employees to put money into an account, which the employer then invests. The payments from a defined-contribution plan depend on how well investments have performed. As a result, the retirement benefits are not guaranteed The most important form of defined-contribution plan today is the 401(k) plan. In recent years, there has been a move away from defined-benefit plans toward defined-contribution plans.

20-8 Participation in Employer Retirement Plans Defined-benefitDefined-contribution Percent of private sector workers who participate All workers2043 Full-time2350 Part- time918 High-wage occupations 3257 Low-wage occupations 1030 Large workplaces 3253 Small workplaces 933

20-9 Social Security The Social Security Act was passed in 1935 to solve the retirement poverty problem. Social Security places a tax (FICA) on current workers to pay the retirement benefits of current retirees. –There is an implicit commitment that future workers will do the same and fund the retirement benefits for today’s workers.

20-10 The Life Cycle with Social Security In principle, Social Security can solve both the retirement poverty problem and the retirement uncertainty problem.

20-11 Where Older US Adults Get Their Money, 2006 Percentage of average income for people 65 and over Earnings from work 24% Social Security 40% Public and private defined- benefit plans 18% Defined-contribution plans and Individual Retirement Accounts 1% Income from assets 15% All other 2%

20-12 How Social Security Works Today Social Security is the best source of income for people 65 and over. There is a a formula for determining your monthly benefits. –That formula depends on the average of your lifetime earnings, adjusted for the rise in average wages over time. –The formula is progressive, so that low- income workers get back a higher percentage of their lifetime average income than better- paid workers.

20-13 How Social Security Works Today There is also a formula to determine how much payroll taxes the employee and employer pay. –Taxes are paid into the Social Security trust fund and invested in Treasury bonds. There is no link between the taxes you pay and the benefits you receive later in life. –Congress can change the benefit formula and the tax rate at its discretion.

20-14 Demographic Challenge The principles underlying Social Security work well if the population and real wages are expanding. But funding becomes more difficult if population growth slows. The old-age dependency ratio is the ratio of the older population to the working age population.

20-15 Demographic Challenge

20-16 Old Age Dependency Ratios in Six Countries

20-17 Will Social Security Run out of Money? Currently, the Social Security program is running a surplus. The surplus is invested in government bonds, so effectively that the Social Security Trust Fund is lending the rest of government money. The problem is in the future, when payments for Social Security benefits will exceed the revenues received from the payroll tax.

20-18 Social Security’s Projected Income and Expenditures through percent of GDP Social Security Income: Taxes plus interest received Social Security Expenditures: Benefit payments

20-19 Fixing the Retirement Shortfall Four possible solutions to the Social Security financing gap: –The first possible solution is a cut in benefits. This need not be an across-the-board cut. This can be accomplished through a higher retirement age or a reduction in benefits for high- income households. –A second solution is to raise the payroll tax, either by increasing the rate or lifting the cap.

20-20 Fixing the Retirement Shortfall –A third possible solution is to fund the Social Security funding gap by using general tax revenues from income and corporate taxes. –The final possible solution is privatization, which would be a major change in the Social Security system. This involves moving more of the decisions and responsibility of retirement saving into the private sector, while preserving a basic safety net for the poor and unlucky. The problem of privatization is the return of the retirement uncertainty problem.

20-21 Basics of Health Care Spending Health care is the largest sector of the economy, accounting for 16% of GDP in Most significant is the fact that health care spending has been growing at a rapid rate. A major challenge for policymakers is to slow down the rate of increase while maintaining care for everyone.

20-22 Per-Capita Health Care Spending Across the World, 2005

20-23 Life Cycle Theory of Health Care In health care, the market consumption decision is not voluntary, but forced by an external event such as becoming sick. There are three type of health events: –First, there’s the flow of ordinary health care expenses when you are young and middle-aged. –Second, there’s the relatively rare catastrophic health event in youth and middle-age. –Finally, there’s the inevitability of a steady stream of old-age-related health expenses as you age.

20-24 Health Care Life Cycle Theory The life cycle theory has three problems: The poor can’t afford to pay for the insurance (the health care poverty problem). It is difficult to predict how much money is needed for health care when retired (health care uncertainty problem). The problem of adverse selection, where healthy people do not buy insurance.

20-25 Health Care Funding Health care is funded by three sources: –The first is spending by individuals on their own. –Second are employer health insurance plans, where companies set up a health insurance plan for their employees. –Finally, the two government-funded healthcare programs. Medicare covers the healthcare costs of older citizens, and Medicaid covers low-income families and children, their caretaker relatives, and individuals with disabilities.

20-26 Rising Cost of Health Care There are six reasons why health care costs are rising at a rapid rate: –Demographic changes are the first reason. The population over 65 is increasing, and they tend to consume more health care than young people. –Second, health care is a luxury good, so as incomes rise, consumption on health care increases. As people become richer, they spend more on health care.

20-27 Rising Cost of Health Care –A third reason is that most health care payments are made by a third party and not the patient. These payers are either a health insurance plan, Medicare, or Medicaid. With a third party, the normal sorts of constraints on purchases are not present. Doctors can order expensive tests and treatments without worrying about the cost, and the patients can agree without worrying about having to pay.

20-28 Rising Cost of Health Care –The fourth reason is the tax deductions for employer health care. Workers receive compensation, in the form of health care, which is not taxed. –Another reason is that the rapid pace of technological change has resulted in the development of very expensive new procedures. –Finally, the practice of bad medicine, where some health care practices do not work.

20-29 Policy Response There is a great debate about what role the government should play in addressing the health care problem. Some economists argue that the US should move toward a single-payer system. –Under this system, the government handles health care, and everyone is automatically covered. –Such a system has several advantages; it eliminates the poverty problem, the uncertainty problem, and the adverse selection problem.

20-30 Policy Response –It also potentially reduces the administrative cost of running the healthcare system. –However, it’s not clear that a move to a single- payer system would slow the growth rate of healthcare costs. At the other end of the spectrum, some economists support the idea of increasing individual responsibility for healthcare spending. –This gives patients an incentive to monitor their own spending.