FORTUNE — By far the most significant — and revolutionary — proposal in Congressman Paul Ryan’s 2012 budget is its blueprint for taming Medicare. According to the Congressional Budget Office’s analysis, issued on April 5th, the Ryan plan would totally reverse the course of recent fiscal history by lowering federal health care spending from 8% of GDP today to just 5% by 2050. If we remain on the current course, the spending would jump to 14% in that time frame.
The centerpiece of the Ryan manifesto is the radical new math it applies to Medicare benefits. In short, Ryan (R-Wis), chairman of the House Budget Committee, would transform the program for Americans ages 65 and older from an open-ended entitlement that threatens to swamp the budget into a system that makes fixed payments to participants each year — payments that would rise at a predetermined, predictable rate. In concept, it’s similar to the defined contribution plans most Americans now depend on for retirement: The government would provide a set dollar payment towards your health care premium, and you’d cover the balance of your health care costs, just as most Americans need to take extra savings from their paychecks for retirement.
But while you can pretty well predict what your 401K will be worth in 30 years if you invest conservatively, the outlook for tomorrow’s Medicare enrollees is far less predictable. The Ryan budget tells us how fast federal spending on Medicare will rise — far more slowly than in the past — but can’t predict how high our medical costs will be 20 years from now, and since the government’s contribution would be capped, how much of those costs we’ll need to pay for ourselves.
In effect, Ryan is asking Americans to make a historic leap of faith. He projects that the newly cost-conscious customers, who’ll inevitably be spending more of their own money, will shop far more carefully for health care. The pressure from those bargain-hunters, and the end to a regime that pays for as many tests as doctors can order, will force physician groups and hospitals to become far more efficient, and offer better prices.
“It’s very speculative how the new system would work,” says Robert Moffitt, a health care policy expert at the conservative Heritage Foundation. “But we know for sure that the Ryan plan would force private providers to compete ferociously for business, and that would introduce a degree of competition into Medicare that’s totally absent today.”
Planning for an uncertain future
Ryan’s vision of bringing the market to Medicare is the best choice in a world of poor alternatives. It’s crucial to understand how his plan differs from his previous proposals, chiefly by eliminating cost-savings from early years and imposing extraordinary limits on payments in future decades. So let’s examine Ryan’s new formula for Medicare.
Here’s a brief overview of how Medicare currently works: On average, the annual cost for its 46 million enrollees is roughly $13,000. The recipients pay total premiums of $1,326 a year for hospital visits and zero for physician services, and can purchase supplementary private Medigap policies that cover virtually all deductibles and co-pays for another $1,500 a year. So the enrollees pay a total of around $3,000, or 23% of the total $13,000 cost. Taxpayers cover the balance of $10,000.
For future retirees and budget-watchers, what matters most is how fast that $13,000 cost number rises, compared with the increase in the $10,000 that the government now pays. Ryan has a solution to the former. The latter is far harder to forecast. The gap between the two will grow, and chart what future retirees will need to pay for their own health care.
For many years, Medicare costs have been growing at between 2 and 2.5 percentage points faster than GDP, a ruinous, unsustainable rate. Even in today’s weak economy, the total Medicare bill is waxing at over 7%.
In two previous proposals, “A Roadmap for America’s Future” and a plan he co-authored with former Clinton administration budget director Alice Rivlin, Ryan recommended replacing the system of covering Medicare’s ever-expanding costs, no matter how fast they grew, with fixed contributions, in about a decade. All of the plans, including the one in the new budget, state that everyone who’s 55 and above will be allowed to remain under the existing Medicare rules when they reach 65. After the program is in place — the starting date in the budget plan is January 1st, 2022 — all Americans would be required to join once they turn 65.
In all the Ryan proposals, enrollees in the new regime would use the government’s contribution to shop from a broad array of private insurance plans offered by a Medicare exchange. That system is modeled on the highly successful Federal Employee Health Benefits Program, where government workers choose from a wide variety of offerings, from deluxe fee-for-service plans to basic high-deductible programs.
But beyond the basics, the proposal in the budget is starkly different from Ryan’s previous plans, a feature that’s mainly overlooked by the press and pundits. In the Roadmap for America, Ryan advocated a voucher system. Under that radical proposal, enrollees would receive a fixed payment of, say, $10,000 a year, in cash. If the senior bought a $7,000 plan, he or she could roll the extra $3,000 into a Medical Savings Account to pay for deductibles and co-pays.
The 2012 budget replaces the voucher concept with “premium support payments” — once again, modeled on the federal employees system — that the government would pay directly to the insurance plan the enrollee chooses. The seniors wouldn’t get to keep any cash that’s left over for out-of-pocket expenses.
The current blueprint is also substantially different from the one Ryan outlined with Alice Rivlin in November. The big change is that the new plan eliminates reforms that would have saved billions before the new regime begins in 2022. Instead, it tightens cost controls once it’s in place.
Rivlin and Ryan proposed a formula that would have imposed a tight cap on the starting contribution a decade in the future. Here’s how it worked: Take today’s average cost to the government of around $10,000 and allow it to grow at GDP plus one point. That’s far less than current growth of GDP plus two percent or more. So the Rivlin-Ryan plan would have notched large savings over the ten years before the program begins by starting with a premium support payment far smaller than the subsidy Medicare would probably be providing by that date.
But in the current budget proposal, Ryan drops that provision. Instead, the new plan would start with whatever subsidy Medicare is providing in 2022, rather than following the restrictive formula in the Rivlin-Ryan plan. The budget contains other important changes. Rivlin-Ryan recommended raising deductibles for doctor visits over the next decade to make patients more price conscious, and mandating that Medigap plans impose far higher deductibles and co-pays — another effort to get enrollees to shop for better deals. The only major change is medical malpractice reform.
The 2012 budget proposal also excludes those requirements. It essentially makes no changes to Medicare until 2022. The transformation is even more draconian than in the previous proposals. The budget plan limits growth of the government’s contribution to inflation, measured by the Consumer Price Index, and also adjusts the payments by the age of the recipient. It is by tying those premium support payments to an index that’s growing far more slowly than current medical inflation that Ryan manages to drive medical spending to just 5% of GDP in four decades.
The plan has other important features. It raises the age for eligibility from 65 to 67 between 2022 and 2033. It also provides sharply reduced subsidies for the wealthy: The top 2% of Medicare earners starting in 2022 would get just 30% of the average payment, and the next 6% would get half the average support payment. The program provides generous cash accounts of over $6,000 to poor patients to fully cover deductible and co-pays.
The big issue is how fast costs grow for the enrollees. With the inflation and age adjustment, the premium support payments will increase at a rate far below today’s relentless escalation of 7% or so a year. The success of the Federal Employees plan is highly encouraging. Its costs are growing at a rate that’s 2% lower than medical inflation in the private sector.
Even if the Ryan plan matches that success, Americans will no longer get more than 70% of their Medicare costs paid by the government. Retirees are bound to pay a much bigger share of their own medical costs. More and more seniors will choose high deductible plans, and HMO or PPO-style programs that limit choices of doctors.
Still, the rise in costs for the elderly could prove far less than the giant annual increases we’re experiencing today. We’ve simply never seen a competitive environment like the one in the Ryan blueprint. “The Obama plan is all about price controls,” says Joseph Antos, an economist at the American Enterprise Institute. “Ryan’s is all about unleashing the market.”
The Ryan plan has another major strength: It will stop heaping a bigger and bigger Medicare burden onto younger taxpayers. Ryan is making a bold, wrenching choice that wins because it’s less painful than all the others.
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