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Medicare is health insurance for all people who are 65 years or older, along with a subset of younger people who suffer from dialysis-requiring kidney failure and a few other disabilities. The program costs $560 billion a year and serves around 49 million people. Medicare benefits break down into four distinct parts.
Part A, “hospital insurance,” covers in-patient stays in medical facilities (including nursing homes and some home care) and generally does not require any sort of premium payment from beneficiaries. Part B is “medical insurance,” designed to replace coverage that seniors used to get through their jobs. Recipients pay a premium that ranges from $99 a month for individuals with adjusted gross incomes under $85,000 (95 percent of all recipients) to $320 for those pulling in $214,000 or more. Part C is a voluntary program, also known as Medicare Advantage, in which beneficiaries enroll with government-certified private insurers who in exchange for a flat monthly fee from the feds provide the same coverage as Parts A and B, typically throwing in extras not covered by standard Medicare, such as vision, hearing, and dental programs. Depending on various factors (such as whether the operator runs a health maintenance organization or a preferred provider organization, whether the insured wants drug coverage or no deductibles, etc.), Medicare Advantage may charge fees on top of the basic premium. Finally, Medicare Part D, which took effect in 2006 under legislation passed as part of the Medicare Modernization Act in 2003, covers prescription drugs. Premiums for drug coverage, which has a mandated annual deductible of $320, start around $25 a month and vary based on the patient’s income, needs, and preferences regarding deductibles vs. co-payments.
When Social Security first started cutting checks, America was still in the throes of the Great Depression. Retirement was a rare and wonderful thing, as most people worked pretty much until the day they died (the average life expectancy at birth was 47.3 years in 1900; 68.2 years in 1950s; and 78.5 years in 2009). When Medicare was created, seniors were more likely than the average American to be poor. Although neither of those things is true anymore, spending as a percentage of federal outlays on both programs continues to grow and shows no signs of slowing down.
Because it is on automatic pilot, spending on entitlements can grow without political consequence or fiscal conscience. Between 1975 and 2000, spending on all entitlements grew at an average annual rate of 3.96 percent, while annual GDP growth was 3.27 percent. Then the ratio really started to deteriorate: Between 2000 and 2010, entitlement spending grew 5.3 percent a year while the economy managed just 1.81 percent. The Great Recession has added a bit to that disparity (Medicaid rolls tend to swell during downturns), but it’s far from the whole story. The aging of the population and the expansion of Medicare to include prescription drug coverage—at a cost of $338 billion from 2006 through the end of 2011—are the major reasons entitlements grow faster than the economy. And given that the oldest baby boomers are turning just 66 this year, we haven’t seen anything yet.
Social Security and Medicare are paid for through a combination of specifically earmarked payroll taxes, general tax revenue, and borrowing. Under the Federal Insurance Contributions Act (FICA), most workers pay 6.2 percent of their earned income in taxes earmarked for Social Security payouts to current beneficiaries (a rate that has been temporarily reduced to 4.2 percent as a means of “stimulating” the economy). Employers kick in another 6.2 percent to the same fund. Over the years, the amount of gross wages subject to the Social Security tax has been adjusted upward; in 2012 it maxes out at $110,100. FICA also levies a tax of 2.9 percent (split equally between employee and employer) to cover a portion of Medicare. The Medicare tax is not subject to a regular compensation limit and is applied to every dollar of wages.
Theoretically, total contributions to Social Security are designed to cover the full cost of the program. That is, the usual amount of 12.4 percent in payroll taxes paid by workers and employers should provide enough revenue to pay for current and future outlays. Historically, Social Security has had far more people paying into the system than drawing funds from it, so the program amassed a surplus in its trust funds that since 1983 has been automatically invested in a mix of short-term and long-term government securities. But those favorable demographics have changed dramatically.
In 1940 there were 159 workers for each beneficiary. Today there are fewer than three. Last fall Mitt Romney, whom the Obama administration accuses of wanting to “dismantle” old-age entitlements, attacked Texas Gov. Rick Perry during a Republican presidential debate for calling Social Security “a Ponzi scheme,” a scam in which current investors are paid profits from new investors, not out of actual returns. “The term Ponzi scheme is over the top, unnecessary, and frightening to many people,” Romney said. That may all be true, but it doesn’t change the reality that current workers are indeed paying for current retirees, not for their future selves, which means that as the number of contributors falls, payouts cannot continue at the same rate. The only options are to reduce benefits, increase contributions, or some combination of both.
While life spans have increased and birth rates have decreased, Social Security’s revenue has not been able to keep pace. In 2010 Social Security entered into a permanent cash-flow deficit, meaning annual payroll tax revenue is no longer sufficient to cover annual benefits. (The last time this occurred was in the early 1980s, when Congress responded by gradually raising payroll taxes and the eligibility age.) For now, benefits therefore must be partially covered by interest income from the assets in the trust funds. After 2021, Social Security will have to cash in the trust fund assets—currently around $2.7 trillion—to pay full benefits until the trust fund is exhausted.
In 2011, according to the most recent report from the Social Security trustees, released in April, Social Security raised $691 billion from payroll taxes and general revenue while paying out $736 billion in retirement benefits. The $45 billion shortfall was covered by money in the plan’s various trust funds. The Trustees’ Report projects that at current tax rates and benefits levels the trust funds will be completely exhausted by 2033. That’s three years earlier than the projections made in 2011 and seven years earlier than projections from 2006. The day of financial reckoning is approaching with accelerating speed. And that situation hasn’t been helped by the temporary two-percentage-point cut in payroll taxes Congress enacted in December 2010 to let Americans keep more of their money during the economic downturn, since Congress refused to offset the reduced revenue with benefit cuts.
Current law holds that when the trust funds are depleted, benefits must be cut to the level of payroll tax revenue. As it stands, that would amount to a 25 percent haircut or, in current dollars, $307 off the average retirement check of $1,229. Compounding the problem is that the government has already spent the Social Security surpluses to pay for other expenses. Absent tax increases or benefit cuts, all operating deficits will not actually be covered by past savings but by new borrowing.
Medicare’s finances are in even worse shape. Costs are rising more quickly, and, unlike the Social Security levy, the Medicare payroll tax was never designed to fully cover benefits. Currently only one-third or so of Medicare costs are covered by payroll taxes, a fraction that will get smaller over time. All told, payroll taxes, along with dedicated funding sources such as premium payments, state transfers, and taxes on benefits, cover around half of all Medicare costs. The rest comes from general tax revenue and borrowing.
Looking down the road, the picture is bleaker still. According to the most recent trustees’ report, the Medicare hospital insurance (H.I.) trust fund will run out of assets in 2024. As with the Social Security trust funds, if the H.I. fund is depleted, Medicare will by law be able to pay out in benefits only what the program collects in taxes.
Even though payroll taxes aren’t enough to fund Medicare and Social Security, they impose a major burden on workers, especially younger workers, who are likely to make less money and thus pay a higher percentage of their income to support retirees who are already as a group more affluent.
Underfunding the Future