Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Chapter 20Chapter 20Chapter 20Chapter 20

The Economics of Retirement and

Healthcare

20-2

Chapter ObjectivesChapter ObjectivesChapter ObjectivesChapter 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 RetirementBasics of RetirementBasics of RetirementBasics 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 CycleBasic Financial Life CycleBasic Financial Life CycleBasic Financial Life Cycle

Youth:Spend on educationand buying a home

Middle Age:Build up savings

Old Age:Use savings for

medical and living costs

Age

Networth Peak earning

years Retirement

Borrowing forhome andeducation

20-5

Problems with the Life-Cycle TheoryProblems with the Life-Cycle TheoryProblems with the Life-Cycle TheoryProblems 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 PlansEmployer Retirement PlansEmployer Retirement PlansEmployer 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 PlansEmployer Retirement PlansEmployer Retirement PlansEmployer 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 Participation in Employer Retirement PlansPlans

Participation in Employer Retirement Participation in Employer Retirement PlansPlans

Defined-benefit Defined-contribution

Percent of private sector workers who participate

Percent of private sector workers who participate

All workers 20 43

Full-time 23 50

Part- time 9 18

High-wage occupations

32 57

Low-wage occupations

10 30

Large workplaces

32 53

Small workplaces

9 33

20-9

Social SecuritySocial SecuritySocial SecuritySocial 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 SecurityThe Life Cycle with Social SecurityThe Life Cycle with Social SecurityThe 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, Where Older US Adults Get Their Money, 20062006

Where Older US Adults Get Their Money, Where Older US Adults Get Their Money, 20062006

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 WorksHow Social Security Works TodayTodayHow Social Security WorksHow Social Security Works TodayToday

• 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.

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How Social Security Works TodayHow Social Security Works TodayHow Social Security Works TodayHow 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 ChallengeDemographic ChallengeDemographic ChallengeDemographic 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 ChallengeDemographic ChallengeDemographic ChallengeDemographic Challenge

20-16

Old Age Dependency Ratios in Six Old Age Dependency Ratios in Six CountriesCountries

Old Age Dependency Ratios in Six Old Age Dependency Ratios in Six CountriesCountries

20-17

Will Social Security Run out of Money?Will Social Security Run out of Money?Will Social Security Run out of Money?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 Social Security’s Projected Income and Expenditures through 2077Expenditures through 2077

Social Security’s Projected Income and Social Security’s Projected Income and Expenditures through 2077Expenditures through 2077

0

1

2

3

4

5

6

7

2007 2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077

per

cen

t o

f G

DP

Social Security Income: Taxes plus interest received

Social Security Expenditures: Benefit payments

20-19

Fixing the Retirement ShortfallFixing the Retirement ShortfallFixing the Retirement ShortfallFixing 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 ShortfallFixing the Retirement ShortfallFixing the Retirement ShortfallFixing 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 SpendingBasics of Health Care SpendingBasics of Health Care SpendingBasics of Health Care Spending

• Health care is the largest sector of the economy, accounting for 16% of GDP in 2006.

• 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 Per-Capita Health Care Spending Across the World, 2005the World, 2005

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

20-23

Life Cycle Theory of Health CareLife Cycle Theory of Health CareLife Cycle Theory of Health CareLife 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 TheoryHealth Care Life Cycle TheoryHealth Care Life Cycle TheoryHealth 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 FundingHealth Care FundingHealth Care FundingHealth 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 CareRising Cost of Health CareRising Cost of Health CareRising 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 CareRising Cost of Health CareRising Cost of Health CareRising 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 CareRising Cost of Health CareRising Cost of Health CareRising 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 ResponsePolicy ResponsePolicy ResponsePolicy 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 ResponsePolicy ResponsePolicy ResponsePolicy 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.