Chapter 20
The Economics of
Retirement and
Healthcare
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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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
20-2
Basics 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.
20-3
Basic Financial Life Cycle
Youth:
Spend on education
and buying a home
Net
worth
Middle Age:
Build up savings
Peak earning
years
Borrowing for
home and
education
Old Age:
Use savings for
medical and
living costs
Retirement
Age
20-4
Problems 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.
20-5
Employer 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.
20-6
Employer 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.
20-7
Participation in Employer Retirement
Plans
Defined-benefit
Defined-contribution
Percent of private sector
workers who participate
20
Percent of private sector
workers who participate
43
Full-time
23
50
Part- time
9
18
High-wage
occupations
Low-wage
occupations
Large
workplaces
Small
workplaces
32
57
10
30
32
53
9
33
All workers
20-8
Social 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.
20-9
The Life Cycle with Social Security
In principle, Social Security can solve both
the retirement poverty problem and the
retirement uncertainty problem.
20-10
Where Older US Adults Get Their Money,
2006
Earnings from work
Percentage of average
income for people 65 and
over
24%
Social Security
40%
Public and private definedbenefit plans
18%
Defined-contribution plans and
Individual Retirement Accounts
1%
Income from assets
15%
2%
All other
20-11
How Social Security Works Today
• 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 lowincome workers get back a higher percentage
of their lifetime average income than betterpaid workers.
20-12
How 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.
20-13
Demographic 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.
20-14
Demographic Challenge
20-15
Old Age Dependency Ratios in Six
Countries
20-16
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.
20-17
Social Security’s Projected Income and
Expenditures through 2077
7
percent of GDP
6
5
4
3
2
1
0
2007 2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077
Social Security Income: Taxes plus interest received
Social Security Expenditures: Benefit payments
20-18
Fixing 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 highincome households.
– A second solution is to raise the payroll tax,
either by increasing the rate or lifting the cap.
20-19
Fixing 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.
20-20
Basics 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.
20-21
Per-Capita Health Care Spending Across
the World, 2005
20-22
Life 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.
20-23
Health 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.
20-24
Health 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.
20-25
Rising 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.
20-26
Rising 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.
20-27
Rising 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.
20-28
Policy 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.
20-29
Policy Response
– It also potentially reduces the administrative cost
of running the healthcare system.
– However, it’s not clear that a move to a singlepayer 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.
20-30