FROM THE OFFICE OF PUBLIC AFFAIRS

October 21, 2004
JS-2090

Remarks of Mark J. Warshawsky
Assistant Secretary for Economic Policy
Social Security & Medicare
Dartmouth College
Hanover, New Hampshire

Thank you for the kind introduction. It is both an honor and a pleasure to be invited to give a talk at this great college. Today I will cover two very important topics, Social Security and Medicare, that either directly or indirectly affects everyone in this room. Although some of you may already be participating or may be pondering participation in these program as beneficiaries in the not-too-distant future, I suspect that most of you are (or should be) interested in Social Security and Medicare as major public policy issues and as programs that could have a significant effect on your long-range financial planning and your tax bills.

The Social Security system began in the aftermath of the Great Depression with the passage of the 1935 Social Security Act that established the "Old-Age" portion of the program. Initially, the program was intended to provide cash benefits to persons age 65 and over who had made payroll contributions to the system with benefits based on the value of those contributions. Contributions would begin in 1937 and benefit payments would start about five years later. An accumulating trust fund would help pay benefits as the number of beneficiaries increased. Even before the first benefit was paid, however, benefit provisions were expanded in 1939 to include spouses and survivors insurance (thus, the OASI system), the benefit formula was made more generous, and scheduled tax increases were delayed. Before 1972, benefit increases were made on an ad hoc basis and four double-digit increases occurred between 1968 and 1972 (20 percent in 1972). Though an accumulating trust fund was envisioned, the system has operated primarily on a pay-as-you-go basis with a modest trust fund having developed in recent years. Therefore, tax increases have been implemented to ensure the continuation of annual benefit payments. But, as we discuss below, the increases fell well short of what would be needed to pay lifetime benefits to a growing and longer-living beneficiary population.

Disability benefits were added in 1956, giving us the present-day OASDI system. At the end of 2003, the Social Security program (OASDI) paid about $470 billion in benefits to about 47 million beneficiaries, making it the largest federal transfer program in the United States.

In 1950, there were 16 workers to support every one beneficiary of Social Security. Today, there are only 3.3 workers supporting every Social Security beneficiary. By the time our youngest workers – like the students in this audience – and others now entering the workforce – turn 65, there will only be 2 workers supporting each beneficiary.

Moreover, in 1950, men and women age 65 could expect to live, on average, 12.8 and 15.1 more years, respectively. In the year 2000, life expectancy at age 65 had increased to 15.7 for men and to 19.0 for women. By 2030, these conditional life expectancies are projected to increase to 17.7 for men and 20.6 for women. Longer lives are clearly a good thing but they also mean a longer period over which Social Security, and Medicare, benefits must be paid.

As a result of these demographic changes the current system will not be able to afford to pay the benefits scheduled for our children and grandchildren without enormous payroll tax increases. The Social Security payroll tax, which was 3 percent in 1950, is now 12.4 percent. The Social Security actuaries calculate that, if the system were to continue to operate on a pay-as-you-go basis and pay currently-scheduled benefits, the payroll tax would have to rise gradually, but steadily, to more than 19 percent before the end of the next 75 years.

But financial pressure on the federal budget (hence on taxpayers) begins much earlier. Tax revenue (payroll taxes plus benefit taxes) is expected to fall short of benefit payments less than 15 years from now, in 2018. Under the current Social Security financing structure, this growing annual revenue gap will be made up from federal general revenues for another 24 years. After 2042 the authorization to fill the gap from general revenues ends, the trust fund is exhausted, and, in the absence of legislation, full benefit payments cannot be made after that point.

The important point is that the Social Security system is significantly under funded – future scheduled revenue will be inadequate to fully pay scheduled benefits. The 2004 Report of the Social Security Trustees estimates that, over the next 75 years, the present value of Social Security's deficit, the unfunded obligation, is about $3.7 trillion. For perspective, this deficit could be eliminated if payroll taxes were raised immediately by 1.9 percentage points to 14.3 percent (and a large Trust Fund would be accumulated) or if all current and future benefits were reduced by 13 percent.

Yet, 75 years, though a seemingly long time, does not capture fully the financial status of the Social Security program. In fact, no fixed finite period will completely embody the financial status of the program because people pay into the system when they are young and receive benefits when they are older and an arbitrary cutoff will miss some taxes and, especially, benefits to be paid. So estimates even over the long period of 75 years include a lot of payroll revenue from future workers who will not begin to receive benefits until after the 75-year horizon. In order to get a complete picture of Social Security's permanent financial problem, the time horizon for calculating income and outgo must be extended to the indefinite future. Such a calculation is provided in the 2004 Trustees Report which estimates that, for the entire past and future of the program, the present value of scheduled benefits exceeds the present value of scheduled tax income by $10.4 trillion. This is the financing gap that program reforms must ultimately close. To put this in perspective, eliminating the permanent deficit would require an immediate and permanent increase in the payroll tax rate of 3.5 percentage points to 15.9 percent (and the accumulation of a massive Trust Fund). Alternatively, all current and future benefits would have to be reduced immediately by 22 percent.

These results make clear that the Social Security system is not financially viable over the long term – it must be fixed, so doing nothing is not an option. How to close the permanent financing gap raises difficult questions over how the burden should be shared across generations. In this context, it is important to recognize that the large unfunded obligations in the system ($10.4 trillion) are in large part the consequence of the past system generosity. From the beginning, the Social Security program made benefit promises to generations that far exceeded the taxes they would pay over their lifetimes. Of course, past generations are past – they cannot contribute to reducing the unfunded obligations. As a consequence, closing the financing gap falls to future generations and this leads to the obvious but very important point that the longer reform is delayed the greater the number of future generations that also become past generations that cannot contribute – that is, delay means a greater burden on the youth of today. Sharing the responsibility fairly of closing the permanent financial gap across generations is one important reason that reform should not be delayed.

Fortunately, this untenable situation is fixable. President Bush has said that "Social security is one of the greatest achievements of the American government, and one of the deepest commitments to the American people." The President supports social security reform that increases the power of the individual, does not increase the tax burden, and provides economic opportunity for more Americans. The President has issued guiding principles for reforming Social Security.

One very important principle is that seniors at or near retirement should be protected from benefit cuts, and that payroll taxes should not be increased.

Another principle is that personal retirement accounts (PRAs) should be made available for younger workers to build a nest egg for retirement that they own and control, and which they can pass on to their children and grandchildren.

Additionally, we must pursue the goal of a permanently sustainable system, eschewing reforms that treat only symptoms and halfway measures.

I would like to focus on the advantages of PRAs. PRAs provide individual control, ownership, and are an important vehicle for pre-funding more of our Social Security benefits without encouraging more government spending. PRAs also offer individuals the opportunity to receive the benefits of investing in the markets. Individual control and ownership means that people would be free to pass the value of accounts to their heirs.

PRAs would also provide many individuals access to capital markets. Particularly people with low income or very little to spare typically have not participated as investors in the securities markets. With PRAs, all workers would have this chance with taxes that currently are sent to government accounts. At the same time, a PRA system should be easy to understand and easy to participate in – without complicated buying and selling features.

The appeal that PRAs have for individuals also serves as an impetus for Social Security reform. Because most people like the idea of ownership and control over their savings accounts, as voters they are more likely to support a reform of this type.

Perhaps most importantly, the retirement security of our current young and future workers depends on PRAs. They allow individuals to save now to help fund their retirement incomes. In principle, that could be done with reforms that save tax revenues in the Social Security Trust Fund. But such "saving" would almost certainly be undone by political pressures to increase government spending and hence produce larger deficits outside of Social Security. The only way to truly save for our retirement and give our children and grandchildren a fair deal is with personal accounts.

PRAs form the basis of a retirement system that gives workers more responsibility for their own retirement saving and affords participants an opportunity to pass wealth to family members in the event of premature death. PRAs also:

• Benefit divorced persons who currently do not receive Social Security spousal benefits unless they remain married ten years;
•  Enable workers to choose how to allocate their retirement saving and diversify their investments over a range of secure bonds and stocks;
•  Do not require frequent adjustments to the larger Social Security system to remain financially sound. As life expectancy increases, adjusting the current system to achieve actuarially fair outcomes is subject to difficult political debate; personal accounts avoid contentious debate and rely on individuals themselves to adjust to the lengthening of life; and
•  Provide incentives to work that are larger and more transparent than in the current system – in a personal account, every dollar contributed can go toward earning a retirement benefit, whereas in the current system, no contributions toward earning retirement benefits are counted until the individual has worked 10 years.

Setting up a new system of personal retirement accounts will require careful planning; the policy options that are chosen could have a significant affect on administrative costs. Questions that a new system will need to address include:

• How would a PRA system be governed?
• To avoid political pressures, an independent board modeled after Federal Reserve Board or the federal employee Thrift Saving Program (TSP) are possibilities.
• To what degree should recordkeeping be centralized?
• The TSP model would have a central administrator that could be a quasi-government agency or a company.
•  How should PRA contributions be channeled to investment managers?
•  To what extent should investment options be limited?
• Particularly at beginning, choices could be limited to "safe" index or mutual funds.

The issues will need to be worked through very carefully as such costs are very important to net returns to PRAs.

The U.S. Social Security system needs to be modernized. Social Security was designed in 1935 amid a very different economic environment. There was a perception then that there were too many workers, so the government wanted to encourage retirement. There was concern then that Americans were saving too much money and not spending enough. Today we are a society with entirely different needs and concerns. We need to continue to make use of the talents of our most productive workers. We need to save more money and we have an abundance of sensible investment opportunities. This is why we have proposed personal retirement accounts. This is the only way to truly save for our retirement and give our children and grandchildren a fair deal.

The Medicare program began under President Johnson in 1966. The program has grown remarkably since the beginning. In 1967, total expenditures fell just short of $5 billion; today, the federal government spends around $300 billion for Medicare. However, the basic structure of the program and its financing have changed little over the time period.

Medicare provides almost universal health insurance coverage to senior citizens and certain disabled people under 65. The program has two separate trust funds: the Hospital Insurance (HI, Medicare Part A) and Supplementary Medical Insurance (SMI, Medicare Parts B and D) Trust Funds. HI pays for inpatient acute hospital services and major alternatives to hospitals (skilled nursing services, for example). SMI pays for hospital outpatient services, physician services, and assorted other services and products through the Part B account and, beginning in 2006, will pay for prescription drugs through the Part D account. Though the events that trigger benefit payments are quite similar, HI and SMI have very different earmarked financing structures. Like OASDI, HI is financed primarily by payroll contributions. Employers and employees each pay 1.45 percent of earnings, while self-employed workers pay 2.9 percent of their net income. Other income to the HI fund includes a small amount of premium income from voluntary enrollees, a portion of the federal income taxes that beneficiaries pay on Social Security benefits, and interest credited on the U. S. Treasury securities held in a relatively small HI Trust Fund.

For SMI, transfers from the general fund of the Treasury represent the largest source of income, covering about 75 percent of program costs for Part B (and Part D beginning in 2006). Beneficiaries pay monthly premiums that finance about 25 percent of costs.

In addition to the financial burdens imposed by an aging society described above, the Medicare program also faces the prospect of continued fast growth of health care costs. The combined forces of high health care cost growth and changing demographics makes the Medicare program in much worse shape financially than Social Security. For the HI program, expenditures are expected to exceed noninterest income this year. That is, the HI Trust Fund is paying out more than it is taking in and is expected to be exhausted by 2019. The 75-year actuarial balance for HI is -3.12 percent of taxable payroll, indicating that the program could be brought into balance for 75 years if payroll taxes were increased by 3.12 percentage points.

There is no comparable actuarial exercise done for the SMI trust fund, but the Medicare actuaries do calculate various estimates of the financial burden created by the entire program. The 2004 Medicare Trustees Report calculates the total unfunded obligations for the Medicare program --that is, the projected expenditures that do not have a dedicated source of revenue--over the infinite horizon to be $61.6 trillion. Put another way, we would have to devote an additional 6.8 percent of GDP every year, forever, to the program to pay off these obligations. Each year we postpone action, though, the problem gets worse.

Unlike with Social Security, the Medicare program does not promise a fixed dollar amount in benefits; rather, it promises comprehensive health insurance for care that essentially meets the standard of those who are privately insured. Thus, the growth rate of health care costs, which is highly volatile, is a major factor in determining the obligations of the Medicare program. The Congressional Budget Office, for one, has projected federal government costs for Medicare under various health care cost growth rate assumptions. Currently, Medicare amounts to about 2.5 percent of GDP. If the per enrollee costs grow at the rate of GDP plus one percentage point, Medicare will, by 2050, comprise 8.3 percent of GDP. On the other hand, if it grows exactly at the rate of the economy, it will only amount to only 4.9 percent of GDP by 2050. Thus, a change in the rate of growth of this program by one percentage point can determine whether the entire economy must devote over 3 percentage points more of its resources to financing the federal government's portion of the program 46 years from now.

Under current reasonable assumptions of projected program cost increases, as in Social Security, these trends are not sustainable. Given the fact that Medicare costs reflect society-wide health care costs, the best approaches to slow the rate of growth of Medicare expenditures are by trying to control the rate of growth of overall health care costs, as well as by specific Medicare program changes.

Some of the most influential research on identifying ways to help us slow the rate of growth of the program is taking place right here at Dartmouth, led by faculty members John Wennberg, Elliott Fisher, and Jonathan Skinner and others. They have done some fascinating research on how expenditures, health care utilization, and outcomes differ for Medicare beneficiaries in different geographic regions of the United States. What they have found is that there are very large differences in regional health expenditures that cannot be explained by differences in illness. Furthermore, Medicare beneficiaries in higher spending areas do not experience better outcomes or satisfaction across a wide range of illnesses than those in lower spending areas. Nor can the differences be explained by area cost-of-living variations. So, how do they explain differences across areas? What they find is that there are huge differences in what they call "supply-sensitive" care, or more frequent use of resources that are not inherently correlated with better outcomes. These include things like more frequent use of the hospital as a site of care, more frequent physician visits, more frequent use of medical subspecialists, and more frequent diagnostic testing and minor procedures.

So, what is the magnitude of these spending differences that seem to have no impact on quality, satisfaction, or outcomes? The researchers estimate that if expenditure levels in all areas of the country were brought down to the lowest decile of Medicare spending, total spending on the Medicare program would fall by 29 percent. In 2004, that amounts to a savings of $85 billion. Now the lowest decile may be too far to go as the standard, because it includes rural areas where we do see access problems, but their results are certainly robust to this refinement.

A few years ago, RAND researchers catalogued studies of waste in the overall health care sector -- many of the studies were smaller in scale than the Dartmouth study -- but reached a similar conclusion. Taking a simple average of those studies, the RAND researchers found that approximately 30 percent of acute care is contraindicated, that is, care that is not recommended. This number, you'll note, is remarkably similar to the 29 percent of wasted medical expenditures that the Dartmouth researchers arrived at. The studies that the RAND researchers examined found high rates of inappropriate hysterectomies, high rates of inappropriate antibiotic prescribing, and inappropriate prescribing of tranquilizers for patients with depression. Furthermore, the authors note that oftentimes patients fail to get recommended care, which could increase expenditures as a result of complications in the future.

All of this suggests that waste and poor quality is not a Medicare-specific problem, but a problem in the health care sector more generally. The question then is, why does the health care system allow so many people to get inappropriate or unnecessary care, and can public policy address this problem, reducing unnecessary or harmful care without reducing proper and due care? There would be many benefits stemming from such an achievement, one of which is the impact on the federal budget. Reducing Medicare expenditures by 30 percent would go a long way towards shoring up the solvency of the Medicare program.

Poor Information. One reason why there is such poor quality in health care is that there is a true lack of understanding of what quality is, and how to get it. From the patient perspective, patients have very little information on how to judge doctors, hospitals, and different medical treatments. People have far more objective evidence to help them choose a digital camera than they do to help them choose a doctor or hospital.

But patients aren't the only ones lacking the information necessary to make wise health care decisions. Providers, too, often lack information on the relative merits of competing treatments. For instance, how do they decide whether to prescribe Lipitor or Zocor to a patient with high cholesterol? There is very little research done comparing the relative effectiveness of treatments. Once a drug or device is approved, doctors are left with little besides personal experience about how to incorporate the new treatment into their medical practice. Researchers find very different rates around the country for a variety of treatments. For instance, there is a six fold variation in the incidence of back surgery in different parts of the country. Also, there are huge variations in bypass surgery rates. This suggests that the culture of medicine varies widely in different parts of the country, even though, ideally, we'd like to see proper care delivered based on objective evidence considering each patient's situation. Such decision-making should lead to more uniform rates of treatment around the country, but more importantly, more appropriate treatment and less wasteful care.

The Medicare Modernization Act of 2003, best known for the prescription drug benefit, has a couple of provisions designed to help patients and providers better understand their health care options. For doctors, the law called for the Agency for Health Care Research and Quality to devote $50 million in 2004 to sponsor research that addresses the information gaps on the clinical effectiveness and appropriateness of specified health services and treatments. There is also a provision that will require hospitals, if they want to receive their full payment for furnishing Medicare services, to submit 10 hospital quality measures. These measures, once collected, will be made public, thus granting consumers objective quality information, which they can use to make informed decisions about where to seek care.

Lack of payment incentives to reward quality. It's reasonable to ask why we face such a lack of information about quality and efficiency, and thus the spread of poor quality and inefficient care, when health care is both so important and so expensive. Well, the fact is, quality and efficiency are poorly rewarded in the health care system. There are two main reasons for this: the first is moral hazard among consumers, and the second is an unusual reimbursement system for providers.

Moral hazard. A potentially serious problem in the health insurance market is the effect insurance can have on behavior, a problem referred to as moral hazard. By lowering the net out-of-pocket price (but not the total price), health insurance induces people to use medical care beyond the point at which the marginal benefit of additional care to them is equal to its true marginal cost. While health insurance coverage is extremely important, and everyone should be protected from catastrophic expenditures, health insurance has taken on an additional function: prepaying for routine expenses. A quick look at data over the last 40 years or so reveals a major shift in how health care is financed. The out-of-pocket share of personal health care expenditures in this country was 55 percent in 1960. By 2002, that had fallen to below 16 percent. Government and private insurers make up the rest of the expenditures. Accordingly, on average, consumers have to pay only 16 cents for every dollar of care they receive. This fosters substantial moral hazard, and health care providers are happy to oblige the consumers. Thus, we see large numbers of diagnostic tests performed on people, even with a tiny expectation of finding anything amiss, and drugs being prescribed that are unlikely to effectively treat an individual's illness.

HSAs reduce moral hazard. The Medicare Modernization Act, enacted last year, included a provision designed to weaken the incentives for moral hazard by creating Health Savings Accounts (HSAs). These accounts allow individuals under the age of 65 who purchase or have a high-deductible health insurance policy to deposit money in an HSA tax-free. They can withdraw money from this account, tax-free, to pay for a wide range of qualified health expenses. Employers can also contribute to this account. Funds can be rolled over year after year and accumulate interest tax free, to be used when the individual encounters health expenses. The result is that, for people with high-deductible health plans and HSAs, there is no longer a tax preference for consuming care covered by insurance versus care paid for out-of-pocket. This reduces the moral hazard problem and makes consumers more demanding in terms of efficient care. And while HSAs are not part of the Medicare program, it is reasonable to believe that changes in care prompted by HSAs will permeate the entire health care system. Thus, when patients start to challenge doctors who prescribe an antibiotic for a viral infection, that doctor will likely change his practice for all patients.

Indeed, the intuition behind the policy motivation for HSAs is supported by rigorous academic work. The Rand Corporation conducted a "Health Insurance Experiment" from 1974 through 1982. The experiment measured both use and health outcomes in populations carefully selected to be representative of those under the age of 65. Participants were enrolled in a range of insurance plans requiring different levels of co-payment for medical care, from 0 to 95 percent (with maximum dollar out-of-pocket expenditures set at $1,000). The researchers found that those who paid nothing used 40 percent more services than those required to pay a high deductible, but the effect on the health status of the average person was negligible. In addition, participants who were assigned at random to a well-established HMO had 39 percent fewer hospital admissions and 28 percent lower estimated expenditures than those in the fee-for-service system, again with no measurable effect on the health of the average person. The increase in inappropriate care from the zero deductible plans actually had negative health consequences to participants.

But in order for patients to be able to make informed decisions about their care, they have to be more knowledgeable about the choices they face. That's why it is important that quality information collection and dissemination be pursued. And as more individuals realize these choices are not trivial, they will begin to demand information about their choices, and we should see these efforts accelerate.

Utilization is basis of payment, not quality or efficiency. We also see that, at the provider level, incentives to provide high quality and efficient care could be made much stronger. Oddly enough, in health care, outcomes are almost never rewarded. So, a doctor will be paid for treating a diabetic who hasn't regulated his blood sugar and shows up in the hospital in a diabetic coma, but he will be paid much less for making sure that the diabetic keeps his blood sugar under control. In health care, utilization is the basis for payment. And while it would be incorrect to say that doctors keep patients sick to increase their incomes, it is difficult to expect doctors to act repeatedly against their own economic interest. But in this age of high rates of chronic disease, such as diabetes and high blood pressure, it is especially important that people get the right preventive care to keep them from having costly acute episodes. The Medicare program has traditionally not done a good job of creating incentives to make sure that people receive proper care. In Medicare, 88 percent of enrollees are in the government indemnity plan. While those people have a nearly unlimited choice of provider, it also means that no one is internalizing the cost of their care and there is very little coordination of providers, two potentially dangerous traits for a chronically ill patient.

The Medicare Modernization Act strengthens the managed care program in Medicare to improve providers' incentives to provide appropriate care. Basically, if an individual enrolls in a managed care plan that costs less than it would have cost the government to care for him, the savings is shared between the individual and the government. So, a managed care plan, to be competitive, will want to make sure their contracted doctors and hospitals are providing the appropriate care, encouraging them to reduce care. Also, because the managed care plan must bear the risk, it will want to ensure that its chronically ill enrollees are receiving proper preventive care. What's more, because the government payments to plans are risk-adjusted, incentives by the plan to shun chronically ill will be substantially weakened, because they will be paid more for taking on predictably higher-cost cases. And as always, if an individual is unhappy with the care he is receiving in the plan, he will always have the option of returning to the traditional government plan. Policies like these will help to reduce waste in the health care sector. Finally, the MMA establishes a six-year comparative cost adjustment demonstration program beginning in 2010 in which the concept of premium support would be applied in a limited number of areas. Enrollees in plans with premiums below the average would receive premium reductions and those in plans costing more than the average would pay the difference.

But the issue of quality in particular deserves mention. There are very few rewards for providing excellent care. Medicare has a demonstration program with Premier hospitals, a network of not-for-profit hospitals, to move us towards a system where quality is explicitly recognized. The Medicare program is collecting information on various measures of quality from each of the 278 hospitals in the study. Those who score among the highest in the group will receive a small increase in reimbursement. Eventually, those who score among the lowest will actually receive a small penalty in reimbursement. The difficulties in moving to a system like this include finding good measures of quality and the ability of providers to actually collect such information. But those barriers are being reduced, as we see hospitals collecting solid quality information as part of the Medicare Modernization Act. The more quality information we have, the more we will be able to hold providers accountable for the care they provide.

I hope I have succeeded today in impressing upon you the urgency of fixing the Social Security and Medicare programs. Even though most of you are decades away from receiving the benefits of the two programs, each year that passes without reform increases your burden in having to fix the financing gap. But by making the right decisions now, we can secure the long-term strength of these vital programs.