Medicare Beyond 2002: Preparing for the Baby Boomers

If Medicare is to provide the baby boom generation the same valuable protection against the ever-escalating costs of health care that it offers current beneficiaries, it must be reformed. The Clinton administration and many in Congress recognize this reality but seem content with modest changes implemented at a gradual pace. The reluctance of policymakers to act more boldly is understandable given the program's popularity among beneficiaries, the political clout of its providers, and its unquestioned societal benefits, which no one wants to jeopardize. But if over the next few years lawmakers do no more than enact incremental changes of the sort proposed by the Clinton administration and many in Congress, they will miss a unique window of opportunity. Medicare will continue to be a chronic policy problem and excessive resources will continue to be devoted to achieving its worthwhile objectives. From the perspectives of participants, providers, taxpayers, and government administrators, Medicare could be a stronger program in the next century if more fundamental structural changes were enacted now and implemented over the 13 years that remain before the first baby boomers begin to draw their benefits.

The Case for Fundamental Restructuring

Medicare needs serious restructuring for three reasons. The first is fiscal. Medicare spending will grow much faster than the economy over the next decade. Both the Clinton administration and the Congressional Budget Office project that Medicare costs will grow at close to a 9 percent annual rate if the program is left unchanged, while the economy will expand just under 5 percent a year. A program as big as Medicare--the third largest in the federal budget--cannot grow almost twice as fast as the economy for long without necessitating drastic cuts in other government activities, big tax increases, or larger budget deficits--none of which appears politically feasible or desirable.

A second reason for fundamental change is the need to bring the structures of Medicare and non-Medicare health insurance more in line. Employer-sponsored plans, Medicaid, and individual insurance are rapidly evolving into capitated systems using panels of providers and some management of care. Medicare remains largely an unmanaged indemnity insurance program paying discounted prices to virtually any licensed provider who chooses to participate. The two systems require different institutional infrastructures to support them, and as they continue to diverge, unnecessary complexity and inefficiencies will develop.

Medicare's glaring inadequacies represent a third, and probably the most compelling, reason for fundamental reform. The standard benefit package offered through employer-sponsored insurance, other public programs, and even many individual policies is far more generous than that of fee-for-service Medicare. Medicare does not cover most outpatient prescription drugs, has no catastrophic protection, and covers few preventive services. As a result, about 70 percent of participants supplement Medicare with employer-sponsored retiree wrap-around policies or individual Medigap insurance. To protect low-income Medicare participants without such policies from large out-of-pocket costs, the government has created a Medicaid safety net. But the safety net is inefficient, inequitable, and inadequate. It saddles states with a cost that should be borne in Washington and does little for many whose incomes are above its eligibility thresholds but too modest to bear, without severe strain, the costs of the services that Medicare covers only partially or not at all.

The problems faced by low- and moderate-income participants are likely to get worse unless Medicare is reformed fundamentally. Employers will continue to pare back or drop their supplementary policies for retired workers. Medigap premiums will grow rapidly as Medicare HMOs draw healthier-than-average participants out of the Medigap insurance pool. Pressure will mount to extend the safety net to more low- and moderate-income participants, thus making the system of protection for the elderly and disabled even more complex and inefficient. And until Medicare is restructured, its inadequate benefit package will be hard to improve.

What Are the Options?

Academics, policy analysts, and policymakers have proposed numerous approaches for restructuring Medicare that they believe can both enhance the protection it provides and save public resources. All would impose a tighter budget constraint on Medicare spending. They differ, however, as to how strong that constraint would be and how it would be enforced.

One approach would privatize Medicare by requiring workers to contribute a fraction of their earnings to special tax-advantaged accounts that they would use to buy health insurance when they retire. The retiree insurance market would be regulated to assure that policies were available, affordable, and renewable. Advocates argue that contributions to the special accounts could be lower than the payroll tax needed to support the existing Medicare program--or that the benefits could be more generous--because the money in the accounts would earn a high return. They also believe that people would purchase insurance prudently, buying neither too much nor too little, because they would be spending their own money.

A privatized system, however, would pose real risk for those with low earnings or long life spans whose accounts could not buy adequate insurance. Conceivably, an entire age cohort could find itself at risk if, shortly before it retired, expensive new medical technologies were developed, inflation jumped unexpectedly, or the value of the financial assets held by the accounts dropped sharply. If Medicare were privatized, it would cease to be a federal budget problem, but public spending on health-related safety net programs would probably have to be expanded.

A second possibility would be to convert Medicare into catastrophic insurance. The deductible could be set high--say, $2,500 a year. The benefit package could be expanded to include services, such as outpatient drugs, that could count toward the deductible. Advocates argue that this approach would hold down costs because people would try to economize on medical spending below the deductible. Above that amount, where much of health spending takes place, risk would be borne by the catastrophic plan, and neither participants nor providers would have any incentive to economize. Many participants would want to buy supplementary policies to cover the catastrophic plan's deductible as well as certain uncovered services. If supplementary policies were permitted, they would emasculate the demand-reducing impact of the high deductible just as Medigap-type policies now undermine the restraining effect of Medicare cost-sharing. Without supplementary insurance, more of the costs of medical care would be borne by the sick and less by the healthy.

A third option is to transform Medicare into a defined-contribution program and give each participant a fixed amount with which to buy coverage from an approved plan operating in a regulated market. These payments, which could be given to the participant as a voucher or paid directly to the plan he or she chooses, would be risk-adjusted and might vary to reflect geographic cost differences as well. There would be no mandated benefit package, and plans whose costs exceeded the federal payment level would be free to charge supplementary premiums. If the plan's costs were less than the federal payment, the participant would receive a full or partial rebate. An accurate mechanism to risk-adjust Medicare's payments to plans, which does not now exist, would be crucial because without a common benefit package disproportionate numbers of relatively healthy participants may choose plans with limited benefits and, therefore, low premiums.

Under a defined-contribution system, the government would have an enforceable budget constraint because it would set the payment levels. Advocates believe that costs would be held down by competition between plans and by participants' strong incentive to join plans that provide quality services at reasonable prices. If health care costs grew faster than Medicare's payments per beneficiary, participants would ultimately be hit by a diminished quality of care, reduced services, or increased supplementary premiums.

Premium support, a fourth approach, resembles the defined-contribution option except that all plans would have to provide the same core benefit package, which would be more comprehensive than that now provided by Medicare. A common benefit package would make it easier for participants to compare plans and for the government to risk-adjust its payments to the plans. Medicare could set payments to the plans through competitive bidding, an option unavailable in the defined-contribution system, which has no common product. The payment in each market area could be set at the median bid. As long as the premium support amount was at least as large as the median bid, low-income participants would have a reasonable choice of plans. At first, only plans willing to accept the premium support amount as full payment could participate. Over time, this rule could be relaxed and plans with higher bids could be allowed to charge supplemental premiums for the basic benefit package, unless the practice badly divided participants by income or health status.

Under both the defined-contribution and premium support systems, a range of plan types--HMOs, preferred provider organizations, provider-sponsored organizations, and fee-for-service insurance--would be available, and the traditional fee-for-service Medicare option would be phased out.

Although no one in the Medicare debate has suggested such an approach, Medicare could also be nationalized--transformed into a National Health Service for the elderly and disabled. Medicare could contract with a limited number of private providers for needed services or employ its own providers, as the Veterans Administration does. Such a system could offer more complete coverage than Medicare does now. The budget constraint could be as strong as it is with the Veterans Administration system.

The alternative to fundamental restructuring is incremental reform. It would hold down federal costs by raising Part B premiums, restraining the growth of payments to providers, and increasing costs to participants through higher deductibles and increased coinsurance rates. Those latter costs, however, would be picked up by supplemental insurance, whose premiums would go up, thus raising costs to participants indirectly. A more straightforward and efficient approach would be simply to raise Medicare premiums. Incremental proposals would also reduce payments to Medicare HMOs--now set at 95 percent of the cost of fee-for-service Medicare. Incremental reform would leave unchanged the basic structure of the existing system--as well as all its problems. Some of the system's perceived advantages, such as the freedom to select one's own providers and to access any available procedure, may erode as payments to hospitals and physicians are continually ratcheted down.

Choosing among the Options

Political feasibility pretty clearly rules out the extremes--both pure privatization and nationalization. Catastrophic coverage would also be a tough sell because the vast majority of elderly seem to prefer health insurance that covers the cost of even routine, budgetable care. The incremental approach undoubtedly is the most politically feasible option now. But as time passes, workers and their dependents, whose taxes pay for most of Medicare's costs, may begin to wonder why Medicare participants continue to have expensive unrestrained access to providers and services when their own employer-sponsored coverage restricts their choice of providers and their access to certain expensive procedures. If a premium support system made Medicare more like employer-sponsored insurance with respect to both limits and benefit adequacy, political support for it might grow.

Of all the alternatives, the premium support approach probably holds the most promise for restraining costs because it would both encourage competition among plans and use the most decentralized mechanism--competitive bidding by plans--to set the government's contributions to the plans. Both the premium support and defined-contribution approaches would be better than the incremental approach at weeding out unscrupulous providers and providing care most efficiently because, in both, the tough decisions would be made by health plans responding to market forces rather than government administrators whose flexibility would be curbed by political considerations.

A system of premium supports also holds the most promise for improving Medicare's benefit package. The package established through the political process would no doubt be similar to those of employer-sponsored plans. Because the defined-contribution approach has no set benefit package, its average benefit package could gradually deteriorate as plans competed with one another for participants. Cost considerations would continue to make benefit expansion problematic under the incremental approach.

When Should Structural Reform Begin?

The sooner the nation begins restructuring Medicare, the more options policymakers will have and the less wrenching the changes will be. Conditions for restructuring are favorable on a number of fronts.

The economy is strong and can accommodate relatively painlessly the unavoidable dislocations arising from a major program restructuring. Demographic conditions are also favorable. The next decade will see a lull before the demographic storm breaks as the first of the baby boom generation turns 65 in 2011. The population aged 65 and over is projected to grow only 0.9 percent a year during the next decade--less than it did during the previous decade and much less than it will in the decade after 2007. This will give any new institutional structures created as part of Medicare reform time to become established before the boomers begin to turn 65.

Health market conditions too are conducive for Medicare restructuring. Providers, particularly hospitals and physicians, are in excess supply. As employer-sponsored plans have constrained their payments to providers, Medicare payments have become relatively generous. Medicare hospital margins--estimated at 12.7 percent for 1997--are higher than they have been in over a decade. Introducing structural reforms while market conditions are good will be unlikely, even with the inevitable slips and stumbles, to restrict access or compromise the quality of care received by Medicare participants.

Even political conditions are relatively favorable. The president is a lame duck. While he may be concerned about what Medicare reform may do to the fortunes of his party, he does not have to worry about his own reelection. In 2001, a new president will be facing reelection in 2004, when about 45 percent of the voters will be 50 and older. With Congress controlled by the Republicans and the White House in Democratic hands, any reform legislation enacted now will bear the fingerprints of both political parties. That won't make reaching an agreement any easier, but it does reduce the chances of demagoguery on the issue in the next election or of policy reversal if one party should control both Congress and the White House.

If restructuring were to start in 1997, how fast should it proceed? Prudence is a virtue in dealing with a program as vital to millions of vulnerable people as Medicare, but the pace preferred by the Clinton ad-ministration risks paralysis. The Health Care Financing Administration (HCFA) wants to demonstrate, test, and evaluate reform alternatives. But the answers to many of the important questions that HCFA is examining will never be clear from experiments and demonstrations that are not systemwide. Opponents of change will use the ambiguity of the results to forestall reforms. Current Medicare providers and participants will have reason to dig in their heels because one of the chief forces driving restructuring is the need to reduce the spending from which both benefit.

When the Republican majority in the 104th Congress passed the Balanced Budget Act of 1995, it showed a willingness to move rapidly on fundamental Medicare restructuring. It erred, however, in rigidly specifying the details of the future program and implementing them over a short seven-year period. No one yet knows just how far restructuring might go in the employer-sponsored health insurance market. It is precipitous to lock in place now a new structure for Medicare for the next century. Restructuring must be an evolutionary, not a revolutionary process.

But if the nation wants to restructure Medicare in ways that can benefit both participants and taxpayers, the process must begin soon and must proceed at a deliberate pace. Medicare restructuring will be complicated, divisive, and time consuming. New institutional infrastructures will have to be built, tested, and revised. Plans, providers, and participants will have to get used to the new structures and incentives. As the process unfolds, some mid-course corrections and adjustments will no doubt be necessary. But such uncertainties should not be used as an excuse for inaction. If meaningful Medicare reforms are not started before this century comes to a close, the window of opportunity may slam shut and the nation may be faced with few alternatives other than to raise taxes to support increasingly inadequate Medicare benefits.