Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

Last week I wrote about the (often misguided) debate over the generosity of public pensions in the state of Illinois.  I ended by noting that it was important to further examine how my previous analysis would change once we account for two under-appreciated facts about the Illinois pension system.    

The first under-appreciated fact is that Illinois is one of a small number of states that provides an explicit constitutional guarantee against the impairment of pension benefits.  Specifically, Article XIII section 5 of the Illinois State constitution states that: “Membership in any pension or retirement system of the State … shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

While Illinois is not alone in providing this guarantee – similar language is included in the constitutions of Alaska, Arizona, Hawaii, Louisiana, Michigan and New York – it should be noted that not all states provide such a guarantee.  In Indiana, for example, the Indiana Court of Appeals (in Haverstock v. State Public Employees Retirement Fund” stated that “pensions are mere gratuities springing from the appreciation and graciousness of the state.”

In a paper that I wrote with David Wilcox in the May 2009 American Economic Review, we discuss just how powerful these guarantees have proven to be over the years.  On the basis of that analysis, I am highly confident that Illinois pensioners will receive their benefits.  Unfortunately, with Illinois having one of the worst records of effective governance in the U.S., most other pensioners and participants are not quite so confident.  One way or another, most of them think, the politicians in this state will find some way to renege (at least partially) on these benefits.  (As an aside, what public servants really have reason to be afraid of is that retiree health benefits will disappear – those are not covered by the impairment clause.) 

The second underappreciated fact is that the public defined benefit pension plans in Illinois are far too complex for the average (or even the highly sophisticated) participant, taxpayer or legislator to properly value.  There are many reasons for this, but mainly it boils down to the fact that the ultimate benefit depends on a lot of variables that will only be known with certainty many years in the future, such as one’s final average salary.  If that were not complex enough, the legislature has made it even more complicated by having multiple benefit formulas in place.  For example, in the “Traditional” defined benefit plan under the State Universities Retirement System (SURS), participants who joined the system prior to July 2005 received a benefit that was the higher of two approaches.  The first was the standard formula (2.2% times years of service times final average compensation).  The second was a “money purchase” option that essentially kept track of the individual’s contributions, matched them with a state match (at least on paper – we already know the state did not really provide the money), and then credited them with an “Effective Rate of Interest,” or ERI.  Then, at retirement, the “balance” in this largely fictitious account was converted to an annuity using an annuity table that used a rate quite close to the ERI.  If the resulting number was higher than the standard formula, the annuitant gets this higher amount instead. 

Confused yet?  If you answered “yes,” don’t feel bad.  Most participants don’t understand all these details.  It is complex stuff that requires a high degree of financial sophistication to truly follow.  If you answer “no,” then let me ask a few extra credit questions.  First, do you know what mean, standard deviation and range the ERI has been in for the last 25 years?  And do you know how the annuity conversion factor compares to market rates?

By this point, I suspect very few people know the answer.  Again, don’t feel bad.  I study pensions for a living, and it took me a lot of time and research to find these answers (and, alas, it was too late – by the time I understood all the details, I had already made a sub-optimal pension choice – and it was unfortunately a lifetime irrevocable one!) 

Without boring you with details, let me give you a flavor of what I have since learned.  The way the SURS board has historically set the ERI, participants in the DB plan were getting an enormously high return (roughly 8-9%) relative to the risk (as measured by the standard deviation in the ERI, which was tiny over the past 25 years), and this high return was being implicitly guaranteed by the taxpayer.  And the annuity rate?  It is substantially more favorable than even the most attractive private market annuity prices – I’m talking in the range of 50% or more benefits per dollar in the “account,” and in some cases, far more.  These two factors explain why most people retiring from SURS in recent years actually received a higher benefit from the money purchase calculation than the basic formula.

What do these two points – the constitutional guarantee and the complexity of the benefit formula – have to do with each other?  Put simply, they have conspired to put an enormous pension funding burden on taxpayers without providing commensurate perceived value to state workers!

Let me explain.  As a result of a complex benefit formula that hides the true value of the pensions – combined with the fact that most participants view the DB pension promises as being at some risk of not being honored – means that most public pension participants do not value the pensions at their full economic value.  This fact partially mitigates the point I made last time because this means the “compensating wage differential” will not be dollar-for-dollar. 

However, the fact that participants discount their benefits in this way does NOT mean that the state is not actually incurring the full economic costs.  Indeed, the constitutional guarantee means that the states’ taxpayers ARE on the hook for the full economic cost of these benefits.

In essence, we have the worst of both worlds.  Public employees are earning a valuable benefit, but because our legislators have (i) created a needlessly complex system, (ii) created a complete lack of confidence in the security of these promises, and (iii) have provided us with a constitutional guarantee that the benefits will be paid, the participants don’t fully value the benefits even though the state bears the full costs.

If any private company did this – providing a costly benefit that was valued by employees at less than the true cost to the employer – that company would soon be bankrupt.  But this is Illinois state government.  So, instead, we continue to build up enormous funding liabilities that will simply be passed on to the next generation of Illinois taxpayers.  It may be “business as usual” in Illinois.  But it’s also a real shame.

Public servants and taxpayers of Illinois deserve better.

In 2008, the federal government’s receipts were 17% of GNP, and its expenditures including transfer payments were 21.4% of GNP (implying the budget deficit was 4.4% of GNP).  If State and Local taxes and expenditures are added to those numbers, they become 30.5% and 35.2% of GNP, respectively.  For many reasons, however, government’s reach is wider than reflected in those numbers.  Government does not just spend its own tax revenue; it spends other people’s money as well.

For just one example, consider environmental regulations.  I have not seen a recent estimate of the total costs of environmental protection, so I will rely on some older numbers.  Note, however, than none of this discussion is meant to imply that the environment should not be protected!   Maybe protections should be more limited, or expanded.  The point is just that measured dollar expenditure by government does not accurately reflect its true size.

In “The Cost of Clean”, the U.S. EPA in 1990 estimated that the total private cost of required environmental protection was approximately $115 billion (in 1990 dollars) or 2.1% of GNP.  By the year 2000, they said the value could approach 2.8% of GNP.  If I assume the same rate of growth through 2008, then these private costs of environmental protection could be as high as 3.5% of GNP by 2008, a figure that would be $514.0 billion, or 21.6% of non-defense federal expenditures.

This cost of environmental protection comes mainly in the form of mandates imposed on firms.  Examples of mandates include the forced adoption of best practices pollution abatement technology or binding emission rates (e.g. limits on pollution per unit of output).  However, these mandates are just like taxes in two respects.  First, the government imposes these costs on private firms.  Second, the mandates provide “public goods” like clean air and water that we all can enjoy.

In other words, if these costs to private firms were converted into an equivalent tax program with direct government expenditures, then U.S. discretionary spending would appear to be 21.6% higher.  These expenditures do not appear explicitly in the federal budget, so they merit further study.  How do we divide our limited resources between private or public consumption, versus private or public investment?  How much of that environmental spending is in each category?  What are we getting for these outlays?  How can we measure the value of the improved environment?  Do these expenditures provide environmental benefits now, or are they investment in the future?

In order address these questions, a full “environmental budget” would need to show each cost, including the cost of complexity created by mandates.  In addition, some environmental protection programs are required by state and local governments (just like taxes).  Each of the programs has implicit transfers from one state to another, and from one income group to another (just like taxes).  Why are these programs not evaluated just like taxes?

I was going to write about whether the high cost of U.S. health care might be driven by medical malpractice.  I was going to say that the best information we have says that malpractice increases health care costs, but only by a small amount.  And, while there seems to be isolated effects on access (e.g., a particular region has a shortage of obstetricians), that effect seems to be rather limited as well.

Then David Leonhardt wrote his Economic Scene article for the New York Times this week saying exactly what I was going to say.  He even cited the same studies I was going to cite.  In the context of the cost of care, the key points from the article are:

• Total Direct Cost of Malpractice Insurance: The combined cost of malpractice insurance, which includes jury awards, settlements and administrative costs, come to about $10 billion a year.  This is about one-half of one percent of medical spending.
• Costs of Defensive Medicine: Malpractice concerns seem to induce doctors to order more care.  A conservative (upper bound) estimate of the cost of this care is about $60 billion per year.  This is about 3 percent of annual medical spending.

So, even if we could eliminate all of the costs of malpractice and defensive medicine, it wouldn’t really solve the cost problem in US health care.

One point that Leonhardt did not raise that I find intriguing is the following.  One of the major drivers of the growth of health spending in the US has been increases in the use of imaging technologies such as CT scans and MRIs.  And, there is evidence that some of the growth in use of imaging technology is driven by defensive medicine.  A 2005 JAMA study by David Studdert and coauthors presents survey evidence in which 43 percent of physicians reported ordering imaging in “clinically unnecessary circumstances.” And, a 2007 study by Kate Baiker, Elliott Fisher, and Amitabh Chandra in the journal Health Affairs found that states with higher malpractice costs are associated with increased use of imaging technology for Medicare beneficiaries.  Now, the way defensive medicine is detected and its impact quantified is by comparing areas with relatively high and low malpractice liability, and it isn’t easy to come by datasets that are amenable to such analysis.  It is entirely possible that, if defensive medicine leads doctors to order more scans in geographic area, ordering a scan might become common practice in nearby areas and, eventually, all areas.  The same is true for doctors who order defensive scans on particular types of patients.  If practices that start out as defensive medicine quickly become generally accepted, then the cost of medical malpractice might be much larger than what we are able to detect in the data.

Even if fixing the malpractice system would not fix the cost of the US health care system, there are still good reasons to think about reforming it.  The current system does not seem to do a very good job of actually preventing medical errors.  As Leonhardt notes, the US has more medical errors than similar countries, and only a small proportion of them (2-3 percent) result in a malpractice claim.   On the other hand, the system often holds doctors responsible for adverse events that are not due to their negligence and makes them liable for, in many cases, huge judgments.  The current system also has the potential to create an adversarial relationship between doctors and patients that is not conducive to improving patients’ health.  I, for one, would rather have my doctor worried about making me well than avoiding a lawsuit.  

So, the current system fails to protect patients’ health, fails to compensate them for losses (whether due to negligence or bad luck), and distracts doctors from working toward improving patient outcomes.  This, rather than the potential to solve the health care cost crisis, would seem to be the compelling case for malpractice reform.

The Chicago Sun Times has recently had a series of articles about public pensions in Illinois.  One of the recent ones – “Public pensions, fat retirements” – focuses on the 4,000 retired government workers that receive pensions of at least $100,000 per year.  The article quotes several people saying things like “it’s both illogical and extraordinarily expensive” to provide such pensions and noting that public pensions are “extremely generous.”

There is no question that public pension funding in Illinois is in need of serious attention.  For those that have not yet noticed, Illinois pension obligations are enormous – and this is primarily the result of many decades of irresponsible budget practices on the part of Illinois politicians who have consistently chosen to underfund pensions.  In essence, the State has a history of not paying its pension bills, and future Illinois taxpayers will eventually have to ante up in a big way.  This is an enormous problem, and one that needs to be addressed.  I will focus more on the fiscal strains of pensions in future posts.

For this post, I simply want to comment on the debate about whether public pensions are really “too generous.”  What exactly does this mean?  (The short answer is that such statements are largely vacuous … read on).

Some people make such statements on the basis of comparing Illinois pensions to those of retirees in the private sector or in other states.  This leads to a whole host of arguments from critics and defenders, such as the fact that Illinois public workers do not participate in Social security.  

At the end of the day, however, none of these arguments are the least bit helpful in answering the question at hand.  The reason is that pensions are only one part of the total compensation package.  To the extent that labor markets in Illinois and the US more broadly are reasonably competitive, then workers are trading pension benefits against other forms of compensation, including wages. 

Most economists believe that workers bear the cost of employee benefits in the form of lower wages.  Let’s suppose a newly minted PhD has been offered positions as an assistant professor at the University of Illinois and at the University of Michigan.  The academic labor market is pretty darn competitive, so the University of Illinois will only be successful at hiring this person if the total compensation package is competitive.  The pension is one piece of that package, but there are numerous other factors at play as well.  If we were to offer an individual a less generous pension, then the University would almost surely have to compensate this person in other ways, such as higher pay, more generous health benefits, more time off, or something else.

So when pensioners say the earned their benefits, they are right.  Not only did they pay their own contributions into the system, but the state contributions (yes, the ones that never actually got made!) were also funded by these very same employees in the form of lower wages.  In essence, state employees accepted lower wages in return for a promised future pension benefit.  

If we believe we have the mix of compensation wrong, then let’s adjust this mix for future workers (we have to focus on the future because the impairment clause of the state constitution restricts our ability to do so for current workers).  But let us not be so naïve as to think that we can cut pension benefits while holding all else equal. 

So at the end of the day it really makes little economic sense to suggest that pensions are “too generous,” given that the pensioners paid for these benefits throughout their careers.  The problem is not pension generosity - the problem is the politicians who could not keep their hands off the money. 

In future posts, I will discuss in more detail how the above analysis changes when we consider two important factors.  First, that in spite of a constitutional guarantee of pension benefits, participants don’t have complete confidence in the inviolability of their benefits.  Second, that the complexity of the pension benefit calculations means that very few participants, taxpayers or policymakers truly understand the true economic value or costs of the benefits that are being provided.  Stay tuned …

A member of Congress who wants to spend additional money often has to say what tax will be raised to pay for it.  Somebody else who wants a particular tax cut for their favorite lobbyist may have to say what other tax will be raised.  As a general principle, this kind of “budget neutrality” is often a good idea.  In all likelihood, the Tax Reform Act of 1986 only succeeded because it was revenue neutral.  It broadened the tax base and lowered tax rates, to fix the tax system without changing the amount collected.

But how is revenue neutrality calculated?  Politicians on both sides of the aisle call upon the non-partisan Congressional Budget Office (CBO) as the arbiter of budget balance.  If important policy choices must pass the CBO’s litmus test, then we need to understand what test is being administered.  According to its website, the “CBO’s [cost estimate] statement must also include an assessment of what funding is authorized in the bill to cover the costs of the mandates and, for intergovernmental mandates, an estimate of the appropriations needed to fund such authorizations for up to 10 years after the mandate is effective” (http://www.cbo.gov/CEBackground.shtml).  This CBO test has a few major problems that could limit the benefits from a policy, or even prevent enactment of a good policy.

First of all, not every act of Congress must be revenue neutral.  But policymakers may want the restriction of revenue neutrality, in order to “prove” they are fiscally responsible.  Recently, President Obama in his health care policy speech to a joint session of Congress promised that he “will not sign a plan that adds one dime to our deficits — either now or in the future.”  Thus, one general problem is: who decides which projects must be revenue neutral?

Second, of course, a project may generate revenue or cost savings after ten years.  President Obama’s health care reform has initial start up costs, but it may “bend” the long-run cost curve for federal expenditures on Medicare and Medicaid, so that cost savings accrue and accumulate over more than ten years.  In general, the CBO’s ten-year balance sheet could say that a policy adds to the debt over ten years, even though it may save taxpayer dollars in the long-run.  On Wednesday, September 16, 2009, the CBO released its official cost estimate for the Senate Finance Committee’s draft health care bill, stating that it would have a “net reduction in federal budget deficits of $49 billion over the 2010–2019 period” (http://cboblog.cbo.gov/?p=354).  However, an additional, unofficial estimate by the CBO concluded that the “the added revenues and cost savings are projected to grow more rapidly than the cost of the coverage expansion”, meaning that over a longer time horizon that the bill further reduces the deficits.

To be clear, the federal debt is a real concern.  Running massive deficits that pile up year after year is unsustainable and irresponsible.  But a strict CBO ten-year cost estimate test may not be the best way to evaluate a potential policy change.

A third problem is that any such test must be somewhat arbitrary, regarding what is counted as “revenue”.  Does it just count actual dollars flowing into government coffers?  What about features of a policy that reduce future outflows?  Some pieces of additional spending in proposed health care reforms are intended to improve future heath and thus to avoid the need for some future medical expenses.  The CBO would count current “preventive care” spending as a cost, but it may not count the fact that this current spending could reduce the need for Medicare and Medicaid to pay for some future medical procedures.

Fourth, and most importantly, even if NOT revenue-neutral, SOME policies are still valuable, important, and worthwhile.  A project may have generalized benefit to everybody in society that exceeds the actual social cost, meaning that it passes a benefit-cost test, even though it requires government spending and is not “revenue neutral”.

Any revenue-neutrality test is a way for policymakers to “tie themselves to the mast” and prevent them from pork spending of the most egregious sort.  Maybe that’s good and worthwhile.  But it may also mean we can’t have some other worthwhile policies either.

Last time I talked about the level of cost in U.S. health care.  Health care costs are high, but I tried to make some arguments for why it might not be crazy for the U.S. to have higher health care costs than other countries.  But, let’s set that aside.  Why? Because the real issue in U.S. health care is not the level of cost, but the rate of cost growth.

Since 1975, U.S. GDP grew at an average real rate of 2.2% per year.  Health-care spending, on the other hand, grew at an average real rate of 4.2% per year.  The extra 2% per year accounted for health care growing from around 7% of GDP in 1975 to 15% of GDP today.  Why is does this matter?  Put simply, tax revenues grow at about the rate of GDP.  So, the revenue base that’s paying for health care is growing much more slowly than its cost.  This means that, even if we were to solve all of the problems with the level of health care cost today, we’d be right back in the same boat in a matter of years.

To see why, consider the following example.  In 2006, U.S. health care costs were about $5,700 per person.  Suppose that without impacting quality we could cut cost by 20%, to $4,560, saving $1140 per person.  This would be a huge success.  But, without addressing the excess growth issue, it would also be a temporary one.  Within about a decade we’d be fiscally right back where we are now.  In 10 years, the $4560 worth of revenue paying for health care would have grown to about $5670, while the $4560 worth of costs would have grown to $6880, totally eating up the original $1140 in savings.

And things would just get worse from there.  In 20 years, health care cost would have grown by an excess of $3000 over revenue.  In 30 years, costs would be about $15,700,  almost double the revenue base of $8760.

And, we haven’t even done anything to increase access or improve quality, both of which would likely increase the level of cost and quite possibly the growth rate as well.

Finally, the aging demographics in the U.S. mean that, if we don’t do anything to curb the rate of cost growth in the U.S., things will actually be even worse.  Since the elderly require relatively more health care, we should expect that as the proportion of the population that is elderly grows, the amount that we spend on health care will grown as well.

As I’ve said before, we’re not just spending more on health care, we’re also getting more.  Certainly, part of the growth in health care expenditures is due to the rapid pace of technological innovation, and the fact that each year the system comes up with new ways to improve and extend life.  But, it is becoming clear to even the strongest supporters of the status quo that something has to give.

There are a number of proposals that have the potential to slow the rate of health care cost growth.  One is payment reform.  Currently, we pay providers for providing more care.  Not surprisingly, this induces them to provide more care.  A system where providers are paid by the episode of care rather than for each service provided might slow the pace of cost growth.  Greater use of information technology, which reduces medical errors and streamlines care, might also help.  Increased investment in cost-effectiveness studies, which will tell us whether a particular procedure benefits patients, whether those benefits outweigh the costs, and, in situations where multiple treatments are available, which provides the greatest bang for our medical buck, also has the potential to lower cost growth.

There is also potential guidance to be found by studying examples of regions and providers that have managed to curb cost growth without sacrificing quality.  For example, a study by Elliott Fisher, Julie Bynum, and Jonathan Skinner that appeared earlier this year in the New England Journal of Medicine shows that there is substantial heterogeneity in growth rates across the U.S., and that some regions, like Salem OR, have managed to control cost growth, while others, like Miami FL, have had substantial excess cost growth.  Other studies have identified particular providers, like the Cleveland Clinic, that have kept costs low.  Of course, anytime you study a cross section, someone is going to have the lowest growth rate.  But, if these groups’ cost controls are real, rather than just statistical flukes, and if they can be replicated more broadly (which is not at all clear), then they might provide the key to solving health care’s most pressing problem.

I don’t know about you, but I have no idea how long I will live.  In most ways, this is a blessing - given how much I like to quantify things, I don’t think I could help myself from starting the grand count-down if I knew my death date for certain.  But in at least one respect - financial planning for retirement - this uncertainty is a real nuisance. 

Fortunately, there are financial products - known by the unsexy name of “life annuities” - that help solve this problem by converting  wealth into a stream of income that will last as long as you do.   There is plenty of research out there showing why annuitization can improve individual well-being by providing a higher level of consumption in retirement.  The problem is that most 401(k) plan sponsors don’t offer them in their plans, and thus most retirees or soon-to-be-retirees don’t have the option to convert their wealth into a guaranteed income stream.

Last Friday, I presented a new policy proposal at a conference sponsored by the American Council of Life Insurers, the AARP, the American Benefits Council, and WISER (apologies if I missed any sponsors!)  The gist of the proposal is to encourage 401(k) and 403(b) plan sponsors to adopt life annuities as the default distribution option from their plans.  The policy steps suggested to encourage it include fiduciary relief and the easing of some administrative burdens associated with qualified joint and survivor annuity rules.  If I may say so myself, the proposal was very well received - including by officials at Treasury, Labor and most of the Congressional staffers present.

Using “automatic enrollment” has proven very successful at increasing 401(k) participation rates, and I believe that “automatic annuitization” could help do the same for increasing annuitization in the payout phase.  This seems a worthwhile goal.  After all, saving assets is not enough to ensure retirement security - you also need a way to ensure that you have enough to live on no matter how long you live. 

I know that this will not make the most scintillating reading for the masses, but you might want to check out the paper anyway.  Whether or not this proposal is ever enacted, I am pretty confident that the future of private sector retirement plans in this country is going to include a greater role for annuitization.  So you may as well start learning about it now … here is the link to the paper.

Social Security is the largest government program in the U.S., with annual expenditures over $600 Billion.  It is also the single largest source of income for the elderly, accounting for 40 percent of all annual income going to individuals age 65 and above and over 80 percent of income for the poorest quintile of families.

Yet, it is less clear whether the program really redistributes income from those who are truly well-off to those who are truly poor.  Although Social Security has a progressive benefit formula, various features of the program reduce the extent of redistribution in the system.

This question matters for the debate over Social Security reform, because most reform proposals try to maintain Social Security as a progressive program and yet might alter the extent of redistribution.  We’d like to know how much redistribution really occurs through the current system, and which aspects of the program’s design influence this redistribution.  Such information would be useful in order for policy makers to assess the distributional effects of any program change.

Three of us undertake such research in a paper called “Is Social Security Part of the Social Safety Net?”, which you can find on my website at  http://works.bepress.com/don_fullerton/ .  My co-authors are Jeffrey Brown and Julia Coronado.  We examine the extent of redistribution in the Social Security system.  To do so, we build a model that categorizes individuals by their lifetime resources, and we calculate the taxes they pay and benefits they receive from Social Security.  Most importantly, we use a number of different definitions of income and of redistribution, in order to obtain a more complete understanding of the issue.

We use 26 years of data from the Panel Study of Income Dynamics to construct complete lifetime earning histories for individuals in the sample.  The use of actual data allows us to incorporate real events and phenomena, such as spells of unemployment, which may be important for the analysis.

We begin by calculating the lifetime net Social Security tax rate for each individual in the sample.  This is the present value of Social Security tax payments minus the present value of Social Security benefits divided by the present value of the individual’s lifetime income.  We then use this tax rate to calculate three different measures of redistribution. The first is a measure of how the Gini Coefficient changes when Social Security is included.  The Gini is a well-known gauge of income inequality that is useful for understanding the overall impact of Social Security on inequality.  The other measures are the average net tax rate in each quintile of the income distribution, and the fraction of individuals in each quintile that receive positive net transfers from Social Security.  The latter two measures are useful for assessing whether the program does indeed benefit those at the bottom of the income distribution.

In addition to the multiple definitions of redistribution, we also employ multiple definitions of income.  The first is the present value of the individual’s actual lifetime earnings.  The second is an individual’s potential lifetime earnings (their earnings if they had worked full-time throughout their adult lives, minus any periods of unemployment).  “Potential earnings” measures the individual’s ability to earn, regardless of how much he or she actually chooses to work.  The third definition pools the earnings of married couples, since their economic well-being depends on total household resources rather than individual earnings.

Here are the major findings.  First, when a more comprehensive income definition is used (potential earnings, or household income), Social Security has virtually no impact on the overall distribution of lifetime economic resources, as measured by the Gini coefficient.  Second, however, while Social Security is not particularly good at flattening the overall income distribution, it nonetheless is at least mildly successful at transferring resources, on average, to the lifetime poor.  Over 85 percent of individuals in the lowest quintile receive positive net transfers from Social Security when the narrowest definition of income is used (individual actual earnings).  As the income definition is broadened, this share falls, but some individuals still receive positive transfers.

Third, transfers through the Social Security system are imperfectly targeted; some high-income individuals receive positive net transfers, particularly when income is defined at the household level, and some low-income individuals do not.  One reason, for example, is that spousal benefits provide more generous payouts to the spouses of high earners.  Finally, we examine whether the extent of redistribution has changed over time and find that the program has become somewhat more progressive on balance, but the direction and extent of the changes depend on the income definition used.

Our research suggests several avenues for future work. The analysis explicitly ignores behavioral responses to Social Security, such as changes in labor supply or savings, which might have an impact on inequality.  Second, our analysis does not incorporate the value of Social Security as an insurance program, for example in providing protection against the risk of disability or unexpectedly long life.  Despite these limitations, the framework we develop could be used to explore the distributional consequences of Social Security reform.

Last week I wrote a bit about quality problems in US health care.  This week, I thought I’d focus on the cost side of the equation.  Let’s begin with a few facts, which are taken from the RAND chartbook “U.S. Health Care: Facts About Cost, Access and Quality.”  For anyone looking for an overview of the facts, this is a great place to start.

Fact 1:  Health care spending in the U.S. is currently around 15% of GDP.

Fact 2:  Although the richer a country gets, the more it tends to spend on health care, the  level U.S.’s health care per-capita expenditures is high.  In 2003, the U.S. spent about $5700 per person on health care.  That was around twice the level of expenditure in other wealthy countries.

Fact 3:  Health care expenditures are growing.  Taking numbers from a CBO study, between 1975 and 2005, real per capita health care expenditure grew at a 4.2 percent rate.  While the U.S. growth rate is high compared to other countries, the U.S. doesn’t stand out in terms of growth rate the way it does in terms of the level of expenditure (see the RAND chartbook).

Fact 4:  Health care expenditures are growing significantly faster than the U.S. economy overall.  The CBO reports that from 1975 – 2005, U.S. GDP grew at about 2.2%.  That means that health care expenditures grew at a rate about 2 percentage points higher than the economy as a whole.

Broadly speaking, facts 1 and 2 concern the level of health care expenditure, while facts 3 and 4 concern the growth rate.  While the level of health care expenditure in the US is high, there is room to debate what the “right” level of health care expenditure is.  It could be that we think hard about our health care system and decide that we want to keep spending more on health care than other countries.  On the other hand, the fact that health care expenditures are growing at a rate faster than the overall economy is a clear and serious problem.  There is no way that the current high growth rate can be sustained indefinitely.

First, why is a high level of health care expenditure not necessarily a bad thing?  If we were using resources efficiently (note: we’re probably not – that’s the subject of a future post) the fact that the U.S. spends a lot on health care could just be a function of our wealth and tastes.  Americans on average are quite rich.  We tend to eat too much and engage in other unhealthy behaviors.  It may be that we’ve decided as our incomes increased to take out part of the gain in wealth by eating more and to compensate for that by using more health care.  We’re fat, and we’re on Lipitor.  The extra money spent on health care undoes some of the bad effects of our unhealthy lifestyles.  Other countries may make different choices – live healthier and spend less on medical care.  But, if we have, as a country, made this choice, then it would be completely reasonable for us to spend more on health care than other countries.

To take another example, it could be that Americans are more likely to insist on expensive medical interventions than those in other countries.  This idea has been in the background of the recent squabbling over whether President Obama suggested the use of “death panels” to determine who should live and who should die.  According to Sarah Palin’s recent piece in the Wall Street Journal, the reaction that Obama was proposing death panels grew in part from a New York Times interview Obama did in April, in which he suggested that we need to think hard about questions such as “whether, sort of in the aggregate, society making those decisions to give my grandmother, or everybody else’s aging grandparents or parents, a hip replacement when they’re terminally ill is a sustainable model,” especially since “the chronically ill and those toward the end of their lives are accounting for potentially 80 percent of the total health care bill out there.”

The reaction was a chorus of “Obama wants to kill grandma!”  (Note: Obama said he would have paid for his grandmother’s hip replacement himself had it not been covered by Medicare.)   While certainly not universal, Americans seem to feel that we should spare no expense in trying to improve the quality and quantity of our (and our loved ones’) lives.  And, good for us!   But, if this is the case, then it should be no surprise that we spend more on health care than other countries.

Now, in everything I’ve said, one thing has been swept under the rug.  Even if Americans do have a particular taste for health care, we should be spending our money as efficiently as possible, and there are many ways in which we can be spending our money more effectively.  But, leaving that aside for now, the issue remains that it is unclear that the high level of expenditure in U.S. health care is necessarily a bad thing.  It might just be an expression of who we are as a country.

Next time: why the real thing to worry about is the growth in health care expenditures, not the level.

Jenny Anderson wrote an interesting article published in The New York Times on September 6, 2009 about the securitization of life insurance policies.  The basic idea in this context is that financiers can package “hundreds or even thousands” of life insurance policies together into bundles and then resell them as bond-like instruments to investors.  The payoffs depend on the lifespan of the individuals in the bundles on whose lives the policies are written.

The article gave a somewhat negative view on the concept, likening it to the securitization of sub-prime mortgages that played a central role in the recent financial crisis.  But in evaluating the financial crisis, we need to be careful not to throw the baby out with the bathwater.  It is true that securitization of subprime mortgages – combined with inadequate underwriting standards for mortgages, the failure of the rating agencies to accurately assess the risks of these securities, and numerous other factors – contributed to the recent financial crisis and the related recession.  But many pundits seem to want to draw a broader lesson from the recent crisis and paint all securitization with the same bad brush.  

“Securitization is bad” is almost certainly the wrong conclusion to draw from the subprime crises.  Indeed, securitization can improve human welfare if and when it is used as an instrument for efficiently spreading risk (in economist lingo, we would say that securitization makes markets more “complete”).  

The rhetoric reminds me a bit of the debate over gun control and the line that “guns don’t kill people, people kill people.”  In this context, it is “securitization doesn’t cause economic crises, people do.”  The key is not to eliminate securitization.  Rather, it is to make sure that the people investing in these products have the information they need to use these securities wisely, and that the people selling them have appropriate incentives for risk management.    

Securitization (which is basically a fancy term for repackaging various types of risk into financial claims or securities that can be traded like stocks or bonds) can be a very useful way of lowering the costs of diversification.  For example, suppose I run a defined benefit pension fund and one of the risks that I face is that all the participants will live a lot longer than I expect.  It would be very valuable for me to have access to a security that pays me a higher return in states of the world in which people start living longer than expected.  In contrast, if I sell life insurance, I might want exactly the opposite security.  Securitization can help institutions hedge these risks more cost effectively because it makes it easier to buy and sell such claims.  It can also help add diversification to an individual’s portfolio because aggregate longevity risk is largely uncorrelated with other financial assets, although I would never recommend that individuals hold more than a very small share of their portfolio in such securities unless they understand them very well.    

Some people may find it odd that financiers would like to “trade on death,” but in fact, there is nothing new here.  Governments have issued “tontines” for hundreds of years to help finance government activities (usually wars, thus financing the taking of life with securities that depend on how long people live!)  My PhD advisor and now frequent co-author Jim Poterba has often told the story about how investors in England back in the 1700s or so would purchase annuities on other people’s lives, and they specialized in finding individuals with above average longevity expectations, and then also do what they could to help keep them healthy and alive.  More recently, there has been much talk in academic and policy circles about the desirability of issuing “longevity bonds” to help make annuity markets operate more efficiently.  

Of course, there are important implications of securitization of life insurance for the pricing of life insurance contracts that need to be considered, particularly if Wall Street is going to package contracts that were written assuming that a high percentage of these contracts would be allowed to lapse before the insured’s death.  Thus, we need to give some thought to how to transition from a world without significant securitization to one where this is done regularly.  But these are not reasons to be against securitization.  Rather, they are reasons to be careful how we do it.