Chapter 18Chapter 18

Economics of Retirement and

Healthcare

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning ObjectivesLearning Objectives

• Apply the life cycle theory of retirement and identify the main sources of retirement funds.

• Explain the difference between defined benefit and defined contribution retirement plans.

• Summarize the demographic challenge facing Social Security and describe the possible solutions.

• Describe the healthcare life cycle, its problems, and the role of health insurance.

• Discuss reasons why healthcare spending is rising so quickly.

18-2

Basics of RetirementBasics of Retirement

• Retirement means that someone no longer has income from work and must finance their 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.

18-3

Basic 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

18-4

Where Adults over 65 Get Where Adults over 65 Get Their Money, 2009Their Money, 2009

Percentage of average income for people 65

and over

Earnings from Work 26%

Social Security 41%

Public and Private Defined Benefit Pensions

18%

Defined Contribution Plans and Individual Retirement Accounts

1%

Income from assets 11%

All Other 3%

18-5

Problems with the Life-Cycle Problems with the Life-Cycle TheoryTheory

• 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.

18-6

Employer 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.

18-7

Employer 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.

18-8

Social 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.

18-9

The Life Cycle with The Life Cycle with Social SecuritySocial Security

In principle, Social Security can solve both the retirement poverty problem and the retirement uncertainty problem.

18-10

How 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.

18-11

How Social Security Works How Social Security Works TodayToday

• 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.18-12

Demographic 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.

18-13

Demographic Challenge of Demographic Challenge of Social SecuritySocial Security

18-14

Will Social Security Run Will Social Security Run out of Money?out of Money?

• Currently, the Social Security program is running a surplus.

• The surplus is invested in government bonds, so, in effect, the Social Security trust fund is lending money to the rest of government.

• The problem is in the future when payments for Social Security benefits will exceed the revenues received from the payroll tax.

18-15

Fixing 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.

18-16

Fixing 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.

18-17

Why Don’t Americans Save? Why Don’t Americans Save? The Personal Savings RateThe Personal Savings Rate

18-18

Basics of Healthcare SpendingBasics of Healthcare Spending

• Healthcare is the largest sector of the economy, accounting for 17.6% of GDP in 2009. That is nearly double the amount spent as a percentage of GDP in 1990.

• Most significant is the fact that healthcare 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.

18-19

Per Capita Healthcare Spending Per Capita Healthcare Spending Across the World, 2008Across the World, 2008

18-20

Life Cycle Theory of Life Cycle Theory of HealthcareHealthcare

• In healthcare, 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 healthcare

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.

18-21

Healthcare Life Cycle TheoryHealthcare Life Cycle Theory

The life cycle theory has three problems:• The poor can’t afford to pay for the insurance (the healthcare

poverty problem).• It is difficult to predict how much money is needed for

healthcare when retired (the healthcare uncertainty problem).• The problem of adverse selection, where healthy people do

not buy insurance.

18-22

Healthcare FundingHealthcare Funding

• Healthcare 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.

18-23

Who Doesn’t Have Health Who Doesn’t Have Health Insurance: 2009Insurance: 2009

18-24

Rising Cost of HealthcareRising Cost of Healthcare

• There are six reasons why healthcare 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 healthcare than young people.

– Second, healthcare is a luxury good, so as incomes rise, consumption on healthcare increases.

• As people become richer, they spend more on healthcare.

18-25

Rising Cost of HealthcareRising Cost of Healthcare

– A third reason is that most healthcare 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.

18-26

Rising Cost of HealthcareRising Cost of Healthcare

– The fourth reason is the tax deductions for employer healthcare.

• Workers receive compensation, in the form of healthcare, 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 healthcare practices do not work.

18-27

Policy ResponsePolicy Response

• There is a great debate about what role the government should play in addressing the healthcare problem.

• Some economists argue that the US should move toward a single-payer system. – Under this system, the government

handles healthcare, and everyone is automatically covered.

– Such a system has several advantages: it eliminates the poverty problem, the uncertainty problem, and the adverse selection problem.

18-28

Policy ResponsePolicy Response

– It also potentially reduces the administrative costs 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.

18-29