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Testimony on the Financial Outlook for Medicare by Richard S. Foster, F.S.A.
Chief Actuary, Health Care Financing Administration
U.S. Department of Health and Human Services

Chairman Roth, Senator Moynihan, distinguished Committee members, thank you for inviting me to testify today about the financial outlook for the Medicare program. I welcome the opportunity to assist you in your efforts to ensure the future financial viability of the nation's second largest social insurance program, one that is a critical factor in the income security of the our aged and disabled populations.

The financial outlook for the Medicare program has improved dramatically since 1997 as a result of the Balanced Budget Act of 1997, together with recent strong economic growth, moderate increases in health costs generally, and continuing efforts to combat fraud and abuse. Even so, there remains a serious imbalance between long-range income and expenditures for the Hospital Insurance (HI) trust fund and growth rates for Supplementary Medical Insurance (SMI) benefits are expected to continue to exceed growth in the nation's economy.

Background

Chart 1 summarizes the enrollment, covered services, and financing provisions of the Medicare program. Information is shown separately for the HI and SMI programs, also known as "Parts A and B,"respectively. As indicated, roughly 39 million people were eligible for Medicare benefits in 1998. HI provides partial protection against the costs of inpatient hospital services, skilled nursing care, post-institutional home health care, and hospice care. SMI covers most physician services, outpatient hospital care, home health care not covered by HI, and a variety of other medical services such as diagnostic tests, durable medical equipment, and so forth.

Only about 22 percent of HI enrollees received some reimbursable covered services during 1998, since hospital stays and related care tend to be infrequent events even for the aged and disabled. In contrast, the vast majority of enrollees incur reimbursable SMI costs because the covered services are more routine and the annual deductible for SMI is only $100.

The two parts of Medicare are financed on totally different bases. HI costs are met primarily through a portion of the FICA and SECA payroll taxes. Of the total FICA tax rate of 7.65 percent of covered earnings, payable by employees and employers, each, HI receives 1.45 percent. Self-employed workers pay the combined total of 2.90 percent. Following the Omnibus Budget Reconciliation Act of 1993, HI taxes are paid on total earnings in covered employment, without limit. Other HI income includes a portion of the income taxes levied on Social Security benefits, interest income on invested assets, and other minor sources.

SMI enrollees pay monthly premiums ($45.50 in 1999) that cover about 25 percent of program costs. The balance is paid by general revenue of the Federal government and a small amount of interest income.

The HI tax rate is specified in the Social Security Act and is not scheduled to change at any time in the future under present law. Thus, program financing cannot be modified to match variations in program costs except through new legislation. In contrast, SMI premiums and general revenue payments are reestablished each year to match estimated program costs for the following year. As a result, SMI income automatically matches expenditures without the need for legislative adjustments.

Each part of Medicare has its own trust fund, with financial oversight provided by thefont Board of Trustees. My discussion of Medicare's financial status is based on the actuarial projections contained in the Board's 1999 report to Congress. Such projections are made under three alternative sets of economic and demographic assumptions, to illustrate the uncertainty and possible range of variation of future costs, and cover both a "short range" period (the next 10 years) and a "long range" (the next 75 years). The projections are not intended as firm predictions of future costs, since this is clearly impossible; rather, they illustrate how the Medicare program would operate under a range of conditions that can reasonably be expected to occur. The projections shown in this testimony are based on the Trustees'"intermediate"set of assumptions.

Short-range financial outlook for Hospital Insurance

Chart 2 shows past income, expenditures, and trust fund assets for the HI program and projections through 2015. For most of the program's history, income and expenditures have been very close together, illustrating the pay-as-you-go nature of HI financing. The taxes collected each year are intended to be roughly sufficient to cover that year's costs. Surplus revenues are invested in special Treasury securities. The Board of Trustees has recommended maintaining assets equal to at least one year's expenditures as a contingency reserve.

During 1990-97, HI expenditures increased at a faster rate than HI income. Expenditures exceeded income by $2.6 billion in 1995, $5.3 billion in 1996, and $9.3 billion in 1997. Prior to the Balanced Budget Act, this trend was expected to continue, with costs growing at about 8 percent annually, against revenue growth of only 5 to 6 percent. The 1995-97 shortfalls were met by redeeming trust fund assets, but in the absence of corrective legislation assets would have been depleted in about 2001. The Medicare provisions in the Balanced Budget Act were designed to help address this situation and, as indicated in chart 2, these changes significantly reduce the growth rate in HI expenditures during 1998-2002. In 1998, income exceeded expenditures for the first time in 4 years. The trust fund is estimated to continue to experience modest surpluses through about 2006. Thereafter, however, expenditures are projected to again exceed income. Assets would be drawn down to cover the resulting shortfalls but would be exhausted by about 2015 under the Trustees' intermediate assumptions.

The depletion date estimated in the 1999 Trustees Report represents a significant improvement compared to the estimate in last year's report (2008). The improvement arises from higher payroll tax revenues in 1998 than had been estimated, together with lower benefit expenditures and adjustments to projected income and expenditure growth for the future based on this experience. The higher payroll taxes in 1998 resulted from robust economic growth, particularly the rapid growth in employment. Lower HI expenditures reflected the implementation of the Balanced Budget Act, low increases in health care costs generally, and continuing efforts to combat fraud and abuse in the Medicare program.

The improvement in the HI depletion date also reflects a subtle but important shift in the near-term operations of the trust fund. As shown in chart 3, the HI trust fund was previously projected to experience small deficits during 1998-2002, and large and growing deficits thereafter. The improvements described above, however, were sufficient to result in modest surpluses during this period, instead of small deficits. As a result, under the Trustees' intermediate assumptions, the trust fund would not begin to draw down assets for another 7 or so years. Thus, the impact of the favorable experience in 1998 is magnified because the transformation of small deficits to small surpluses significantly delays the onset of the fund's depletion.

Long-range financial outlook for Hospital Insurance

The interpretation of dollar amounts through time is very difficult over extremely long periods like the 75-year projection period used in the Trustees Reports. For this reason, long-range tax income and expenditures are expressed as a percentage of the total amount of wages and self-employment income subject to the HI payroll tax (referred to as "taxable payroll". The results are termed the "income rate" and "cost rate," respectively. Projected long-range income and cost rates are shown in chart 4 for the HI program.

Past income rates have generally followed program costs closely, rising in a step-wise fashion as the payroll tax rates were adjusted by Congress. Income rate growth in the future is minimal, due to the fixed tax rates specified in current law. Trust fund revenue from the taxation of Social Security benefits increases gradually, because the income thresholds specified in the Internal Revenue Code are not indexed. Over time, an increasing proportion of Social Security beneficiaries will incur income taxes on their benefit payments.

Past HI cost rates have generally increased over time but have periodically declined abruptly as the result of legislation to expand HI coverage to additional categories of workers, raise (or eliminate) the maximum taxable wage base, introduce new payment systems such as the inpatient prospective payment system, etc. Future cost rates are projected to initially decrease as a result of the Balanced Budget Act provisions. After 2002, however, cost rates would increase steadily and accelerate significantly with the retirement of the baby boom, beginning in about 2010. Closing the HI deficit over the first 25 years would require either an 11-percent reduction in benefits or a 12-percent increase in income, or some combination, starting immediately. Over the full 75-year period, the adjustments would have to be considerably greater. The good news is that, as a result of the Balanced Budget Act and the favorable experience of recent years, the long-range actuarial deficit is only one-third of the level projected prior to the BBA. The bad news is that, even so, the remaining imbalance is considerable.

The effect of the baby boom's retirement on Social Security and Medicare is relatively well known, having been discussed at length for more than 25 years. Basically, by the time the baby boom cohorts have retired, there will be roughly twice as many HI beneficiaries as there are today. When the HI program began, there were 4.5 workers in covered employment for every HI beneficiary, as shown in chart 5. Currently, this ratio is 3.9 workers per beneficiary. With the advent of the baby boom's retirement, the number of beneficiaries will increase more rapidly than the labor force, resulting in a decline in this ratio to 2.3 in 2030 and 2.0 in 2050 under the intermediate projections. Other things being equal, there would be a corresponding increase in HI costs as a percentage of taxable payroll.

There are other demographic effects beyond those attributable to the varying number of births in past years. In particular, life expectancy has improved substantially in the U.S. over time and is projected to continue doing so. The average remaining life expectancy for 65-year-olds increased from 12.4 years in 1935 to 17.4 years currently, with an estimated further increase to over 20 years at the end of the long-range projection period. Medicare costs are also sensitive to the age distribution of beneficiaries. Older persons incur substantially larger costs for medical care, on average, than younger persons. Thus, as the beneficiary population ages over time they will move into higher-utilization age groups, thereby adding to the financial pressures on the Medicare program.

The key factors underlying past and projected increases in HI expenditures are summarized in chart 6. Aggregate cost increases have been factored into (i) growth in the number of beneficiaries, (ii) increases in general inflation, as measured by the Consumer Price Index, and (iii) all other factors, reflecting per capita increases in the utilization of health services and in the "intensity" (or average complexity) of such services. Through the early 1980s, general inflation was a major contributor to growth in HI costs. The "all other" category has seen major swings in the past, from average annual increases of as much as 6 percent to as little as 0.7 percent.

Under the intermediate projections, the impact of the baby boom's retirement clearly shows up in its effect on beneficiary growth rates. The Trustees project a fairly constant rate of inflation at about 3.3 percent annually. Projected growth in the "all other" category varies significantly, reflecting the net impact of several factors. Initially, residual growth rates are low due to the impact of the Balanced Budget Act. After 2002, utilization is expected to reaccelerate, although not as severely as in past years, due to the new prospective payment systems mandated by the Act. Future demographics will also play a role: as an influx of 65-year-old baby boomers arrives, average per capita utilization will actually decrease temporarily, as the average age of beneficiaries declines. As the baby boom generation ages, however, their utilization will increase and drive up residual HI growth rates overall.

A final factor affecting the residual growth rates shown in chart 6 is an assumption that health costs cannot continue to grow indefinitely at the high rates frequently experienced in the past. A simple extrapolation of the past quickly leads to a situation where Medicare alone would represent a substantial portion of total gross domestic product, an untenable and unrealistic situation. For this reason, residual growth rates are purposely assumed to gradually moderate toward the end of the first 25-year projection period. This assumption has been used for many years and has been found appropriate in the past by independent panels of expert actuaries and economists. More recently, however, it has received considerable criticism. Accordingly, I have asked my staff to carefully review the long-range Medicare growth assumptions. In addition, the Board of Trustees is convening a new expert panel for the purpose of reviewing the Medicare trust fund projections. We will also ask this group to review the long-range growth assumptions.

Financial outlook for Supplementary Medical Insurance

Chart 7 presents estimates of the short-range outlook for SMI and is generally similar to the information presented in chart 2 for the HI program. Two key differences stand out: First, the income and expenditure curves for SMI are nearly indistinguishable in the future. As noted previously, SMI premiums and general revenue income are reestablished annually to match expected program costs for the following year. Thus, the program will automatically be in financial balance, regardless of future program cost trends. The second difference is the relative level of trust fund assets. Since financing is reset frequently, a lower level of assets can suffice for contingency reserve purposes.

The primary concern for SMI is the rapid rate of growth in benefits. SMI costs grew by 41 percent over the last 5 years, exceeding the growth in the nation's gross domestic product (GDP) by 9 percent. Similar growth is projected for the short-range future. Although the Balanced Budget Act contained a number of provisions designed to reduce the rate of growth in SMI expenditures, their impact is more than offset by other factors. First, the Act specified that home health services not associated with a prior stay in an institution were to be converted to Part B benefits and paid for by the SMI trust fund (phased in over several years). In addition, the Act provides for several significant new preventive or "screening" benefits, such as colorectal examinations, not previously covered by Medicare, and it gradually corrects an excessive level of beneficiary coinsurance for outpatient hospital services. As a result, SMI costs are estimated to increase somewhat as a result of the Balanced Budget Act.

The increase in SMI costs is offset by additional premium revenue under a provision to maintain the SMI premium at the level of 25 percent of expenditures. Prior to the Balanced Budget Act, premium increases would have been limited to the Social Security cost-of-living adjustment (COLA) and, over time, would have represented a declining share of total costs. The Balanced Budget Act makes permanent the current relationship between premium revenue and total costs.

The long-range cost of SMI (shown in chart 8 as a percentage of GDP) is expected to follow the same general pattern seen previously for HI. In contrast to HI, these costs will automatically be met through enrollee premiums and general revenues of the Federal government. Policy makers remain concerned about continuing rapid growth in SMI expenditures.

Conclusions

In their 1999 report to Congress, the Board of Trustees notes the substantial improvements in the financial outlook for Medicare that have come about as a result of the Balanced Budget Act of 1997, together with recent strong economic growth and relatively slow growth in health costs generally. But they emphasize the continuing financial pressures facing Medicare and urge the nation's policy makers to take further steps to address these concerns. They also argue that consideration of further reforms should occur in the relatively near future. Today's relatively favorable conditions could change, accelerating the expected return to deficits in the HI trust fund. Moreover, the earlier solutions are enacted, the more flexible and gradual they can be. Finally, the Trustees note that early action increases the time available for affected individuals and organizations, including health care providers, beneficiaries, and taxpayers, to adjust their expectations.

I concur wholeheartedly with the Trustees' assessment and pledge the Office of the Actuary's continuing assistance to the joint effort by the Administration and Congress to determine effective solutions to the remaining financial problems facing the Medicare program. I would be happy to answer any questions you might have on Medicare's financial issues.