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As health care costs skyrocket, employers are finding it increasingly difficult to offer comprehensive health benefits, and the burden of health care financing is gradually shifting to the consumer. According to experts at Booz Allen Hamilton, consumers will need to meet this challenge by planning for their health care costs as they do for their other financial expenditures, by tapping into products aligned with the financial services life planning cycle. strategy+business and Knowledge@Wharton recently spoke with Joni Bessler, vice president at Booz Allen Hamilton, and Kent Smetters, professor of insurance and risk management at Wharton, about what this “health-wealth” convergence could look like. In this first part of a three-part interview, Bessler and Smetters discuss whether a health-wealth convergence is inevitable, and how financial planning tools such as health savings and health retirement accounts will figure into the future of health care.
Click here to listen to PART TWO of the interview.
Click here to listen to PART THREE of the interview.
T R A N S C R I P T :
strategy+business: Let’s start with an overview of where we are and how we got here in the U.S. health care system. Kent, why don’t you start us off?
Kent Smetters: Sure. The U.S. health care system is a result of part historic accident and part purposeful policy on the part of the U.S. government. Right now, most health care in the U.S. is still provided through employers in a way that employees face fairly little risk. There might be a small co pay or something like that, but for the most part there is very little risk on the part of employees. And insurance economists, like myself, think that is crazy. Insurance is really to cover the big losses, not first dollar.
So the question is, “How did we get here?” And it is partly a result of two things. The first is that the current tax system encourages employers to lean more toward providing benefits instead of wages because the benefits from the employee perspective are provided on a pre-tax basis. So, they want to load up on that artificially more than what they would if they had to actually pay taxes on those benefits.
The second thing is more of an historic accident. During World War II, employers were prohibited from paying higher wages. Remember, there was a huge scarcity of labor at that time. The men, to be a little stereotypical, were off fighting the war and there was a real scarcity of labor. The U.S. government basically said there are price controls; you can’t pay too-high wages. So what did firms do? The firms competed by offering very generous benefits, and that implied things like first-dollar coverage for health care. That created a standard in the U.S. that health care benefits meant insurance immediately covers that first dollar of coverage even though, as insurance economists, we think that’s a silly design.
Joni Bessler: That also created a tremendous level of opaqueness. As a consumer, you had no visibility into what your health care expenditures really cost, either to you or to the employer. As a consequence, the cost—as we have seen—just skyrocketed.
Smetters: Right. If you don’t face the marginal cost of something, if it has any benefit at all, your cost is zero; as the employee, you just want it.
Bessler: Let me fast-forward a decade, because what Kent just described is what we call the “wholesale model,” or the B2B model. You have heard the term “indemnity plan.” Blue Cross/Blue Shield plans offered those indemnity plans. But we then entered a period of escalating costs—and many of us remember the HMO era, which hit in the early 1980s. It was an attempt to control those costs but still very much the model that Kent just described. It was largely first-dollar coverage, it was opaque and it was a B2B model. So it was still the employer buying health insurance on behalf of the employee. And, as we have now had the opportunity to see, for the most part HMOs did not accomplish what they set out to accomplish.
Knowledge@Wharton: Is the cost shifting to individuals at this point?
Bessler: What we are now seeing—and it really started about a decade ago—is a shift from this wholesale model, as we’ve called it, to what we are now calling a “retail model” -- much more of a B2C model where we are asking the consumer or the individual to bear an increased percentage of their health care risk, their health care expenditures, and really the decision for how they are going to seek health care services. So, we have moved away from the employer making the decisions on behalf of the individual, for the most part, to the individual being at the center of the decision-making.
Smetters: And I would say that is in many ways a good thing, because employees now face some marginal cost, at least in terms of some of the early decisions; going to a doctor—things like that—now cost them some money, so they actually make the right trade off between cost and benefit. And that is probably a good thing. Economic theory would say that if employees are getting less generous benefits, they get more wages in response because they care about the whole compensation package. So that shift toward maybe higher wages, less benefits, where they face some cost incentives, is probably a good thing—provided, of course, in terms of catastrophic costs. Those were still being covered. And that is basically what we are starting to see.
strategy+business: Can you talk a little, Kent, about the dynamics of the shift, what’s driving these changes?
Smetters: Well, if you were to talk to labor unions, they’re just saying companies are being cheap. I think that is really simplistic. And I think it is simplistic because this is the transition that we insurance economists think is the ideal outcome. There might be some disagreement here on this, but at least this is the direction I think we should be going.
And I think the problem with the previous system is that it had a lot of moral hazard. And that is, if you didn’t face the costs, then you just simply over-utilize. With this newer approach, in particular large-deductible plans—HSAs, things that we’ll talk about—employees now face some marginal costs, and they are going to make the right cost-benefit decisions.
I’ll give you a quick example. I grew up in a very poor family and we didn’t have health care. I can count on one hand the number of times I have been to a doctor up through graduate school, whereas [the family of] my best friend growing up had health care coverage from their employer. Every time he had a sniffly nose, if he coughed a little bit, he couldn’t come out to play because he was at the doctor’s. And that just seemed pretty crazy to me. That is the problem with first-dollar coverage: There is really no incentive to not go to the doctor for that sniffly nose, that cough and so forth, even though you probably shouldn’t be going to the doctor for that type of thing.
So, I see this transition as a very good thing, controlling for moral hazard, and I don’t agree with the simplistic notion that it is just that higher-cost companies are simply cutting back. Yes, the higher costs are putting pressure on them to think harder about how to be more efficient, but I think this direction is the right direction.
Bessler: Let me build on that for a moment, because perhaps what you were just driving at is what we see now. At the bottom line, we have seen a huge escalation in health care costs, and that is the issue. If you take a look at your average family’s premium costs, they have gone up about 87% since 2000, at a time when wage inflation is somewhere around 18% or 20%. So, the inflationary costs of health care are far outstripping inflation and wage increases. It has just gotten to the point where the employer cannot continue to offer benefits in the same form as they have historically.
Knowledge@Wharton: I recently read a piece by you, Joni, and some others at Booz Allen who suggest that health care should look to the financial-planning life cycle as a model, or maybe as a future means, of solving some of these issues. Can you elaborate on that a bit?
Bessler: The underlying premise of that article is that the consumer will need to start to think about planning for their health care costs as they plan for their other financial expenditures today. Those of us who recently got married and bought a house planned for the purchase of that house. If you have children, you planned for the birth of your children, you then planned for their schooling costs, and so on and so forth. And most of us plan to set aside money for various stages of our life cycle. The issue with health care is you’ve never had to plan for your health care cost because it has always been provided by your employer and, in fact, it was viewed as an entitlement.
So, the underlying premise is that those days are shifting, and you now need to begin to plan for your health care expenditures. It’s tricky, because health care in many cases is not predictable in the same way as some of those other costs. Generally, you know if you are planning to buy a house. You generally know if you need to send your kids to school.
Some health care expenditures are predictable. Maternity generally is. Other things, in particular some of the high ticket expenditures, are not; you have these huge spikes in internal demand, and you need to make sure you’ve put the money aside.
If you’ve read some of the literature, it becomes particularly acute when you hit retirement age. It’s now estimated you may need upward of $300,000 to cover the cost of your health care in the post-65 years. That’s the underlying premise of the article and the need to shift more toward what we’ve called financial-services life-planning cycle.
Smetters: It really gets enhanced with the problems that Medicare faces. Medicare faces tremendous financial shortfalls.
What Congress tries to do today is continue to cut back on the reimbursements they are going to pay for different diagnosis-related groups. As a result, I think you are going to see more and more doctors simply drop out of the Medicare system. They don’t have to take Medicare. There’s no law that obligates them to take it. As a result, more and more people are going to be finding themselves on the hook for their own health care expenditures.
Bessler: It’s not just Medicare for those over 65, because you’re seeing significant actions taken by the private marketplace to scale back benefits, or at least scale back their risk for those benefits. Witness the landmark agreement that happened recently between GM and the unions.
Smetters: That’s a very interesting agreement. From a workers’ perspective, if everything goes as planned, they get the investment returns when they open that trust fund. It will be a pretty similar interface for them. They’re not going to notice a huge difference.
There’s a very good chance they are not going to get that equity premium that they’re hoping for. It’s a $50 billion dollar liability, and they’re only putting aside $35 billion today. They are obviously hoping for very strong investment returns. If those investment returns don’t materialize, then workers, again, are going to be on the hook for some of their health care costs.
Bessler: If you remove yourself from the GM example specifically, the really interesting thing as a consultant in this industry is that it’s a dramatic shift from defined benefits to a defined contribution. It’s certainly a path that many employers, as we’re out there talking, would like to see. It enables them to continue to provide health care for their retiring population but in essence cap their risk.
Smetters: Right. We saw a similar transition obviously in the past couple of decades in terms of pensions. Almost no new employer opens up a new defined-benefit plan. It’s almost all defined contributions. The difference there is, of course, that defined-benefit plans in pensions really had this additional problem, and that is this lock in problem in which workers really didn’t necessarily want defined-benefit plans themselves. Yes, it took away some of their own retirement risk. On the other hand, if they ever changed an employer, they lost a lot of accumulation in terms of value. A defined-contribution plan is much more portable.
That part of the analogy probably doesn’t work for retiree health as much because there’s not quite that same lock in effect. But, still, it is a similar model where we’ve seen more of the risk pass toward the worker.
strategy+business: We’ve talked about how the burden is shifting from the employer to the employee. How does that actually show up? I’m really getting to HSAs and HRAs. Can you talk a little about those?
Bessler: Before I do, let me give you some of the statistics that illustrate what has happened if you are a consumer in this new health care market.
If you look at the total out of pocket expenditures that an employee or a consumer is now bearing—that would include their contribution to their premiums, their co pays, their deductibles, and the things that Kent mentioned—they have jumped about 65% from 2001 to 2006, from about $2,600 to about $4,200. It’s really huge.
About 20% of our insured market now pays more than 10% of their net income toward health care, which is mind-boggling. That’s a huge percentage of their net income going to cover health care costs. Consumers are really feeling the crunch of the environment that we’ve been speaking to—this shift toward a retail environment.
I probably don’t need to tell anyone that the uninsured is a huge issue in this country. We’re now up to somewhere around 47 million people. It’s a huge, huge issue. That’s kind of a snapshot.
HSAs and HRAs were introduced as a means to begin what Kent was referring to—to encourage individuals to begin to plan for their health care expenditures. They both need to be combined with a high deductible health plan, meaning a health plan that requires a significant up-front deductible.
The biggest difference between the two is that one is held by the employer and the other is portable. The HSA is portable; the HRA is held with the health plan. It’s basically a tax-advantaged savings account where you can deposit money and then use the money in those accounts for designated health care expenditures.
Smetters: The nice thing about this model is it allows for the conversions Joni talked about earlier, between the difference sectors—in particular, with the health savings account. Money that’s left over by the time you hit retirement you can convert to non health consumption. It does allow a 401(k)-type aspect to it.
That’s different than some of the “use it or lose it” type of medical savings accounts that we’ve had in the past, where you actually had to spend the money in a particular year or else you lost it in order to get the tax advantage.
You can imagine at some point in the future where you have one big, tax-deferred account that is used for practically everything. You can tap into it for health care, tap into it for college. Anything that’s left over, that’s your retirement income. That would be a very simple interface, and there would be lots of advantages to that instead of having all these 529, 401(k), Coverdell and everything else floating around.
strategy+business: Do you see HSAs and HRAs as a first step toward that?
Smetters: I think Joni would have a good industry opinion of that. Politically, yes. HSAs were part of a political compromise, in part as a result of Part D Medicare. Part D Medicare is the prescription-drug benefit—a disaster, in my opinion, in how it’s constructed. Part of the political compromise to get the right wing involved was introducing this more free-market element into it. And that was the HSAs.
Now, personally, I would have been willing to give up the HSAs in exchange for just not having this disastrous prescription-drug benefit that’s not going to be very costly, it’s just very poorly done. Yes, it’s a small step in that direction. Hopefully, we can get more and more leverage that way.
Also, politically, it’s part of this whole convergence that’s going on. There’s a lot of thought about workers not participating, for example, in their 401(k) plans. So, how can we start getting things like automatic enrollment, which is a huge issue that is being discussed in Washington right now? Can we get the workers automatically enrolled in these plans?
It’s a lot easier to think about automatic enrollment if you’re talking about one thing that they’re automatically enrolled into that covers a whole span of different risk. If you’re talking about automatic enrollment in terms of a 401(k) retirement savings plan, that’s pretty narrow. Now we start thinking about automatic enrollment in lots of things like HSAs and so forth. That could intellectually be a lot easier to do if it’s all converged into one wrapper for the employee.
Bessler: I would agree with Kent. We do see it as a first step, and a very important first step, because it is the first time that we have started to put the money into the hands of the consumer for their health care expenditures. But it’s very much a first step. Today, they represent only about 7% of the employed population. It’s still very small.
They’ve accomplished some very important milestones, but there’s still a lot of discussion around what exactly they can be used for—which chronic conditions, for example. Insulin was just recently covered. But there are other chronic drugs that are still not covered. You can pull the money out of your HSA, but the question is, can they be 100% covered before you have to tap into your HSA? So, I’m exactly where Kent is. I think we will see them morph either into different types of products or be combined with other types of products as we see the innovation cycle unfold over the next three to five years.
Smetters: I’m advising a start up in Los Angeles. Their health care plan is all HSA based. I think it’s very hard to get an existing system converted over to HSAs. But, as you see more newer companies come along, they’re going to adopt HSAs. And we saw the same thing with defined benefit/defined contribution, where conversion from defined benefit to defined contribution had lots of controversy associated with it, whereas new companies almost exclusively do defined contribution. Hopefully, over time we’ll see this shift in HSAs as well.
Bessler: Let me pick up on that point, because I think it’s really important. The majority of employers today still offer HSAs as an option, so most employees still have a choice of at least one other plan, whether it’s an indemnity, PPO, point of sale, HMO, and they’ve now offered HSAs. I’m of course speaking a bit stereotypically here, but for the most part, HSAs are going to attract your younger, healthier population who do not see health care expenditure as a major concern. Remember, there’s a high-deductible piece attached to it, and if they know they’re going to be incurring major medical expenditures, they’re not going to sign up for the high deductible.
So, what will happen in the near term is the younger, healthier—we call them “the young invisibles”—are more likely to be attracted to the HSA product. As employers go toward more of what you were talking about, the total replacement model, so that everybody is going into an HSA-type product, we will begin to see a very significant shift. And that’s just starting to happen.
Smetters: One way the employers can make it less painful is…first of all, sometimes it’s a new employer, and so there are no existing workers that can make this comparison between the old plan and the new plan. But what we do, for example, in the start up in Los Angeles is we say we’ve got this deductible, we’re going to contribute some money toward that deductible. And it’s actually cheaper still for the employer to put some money toward that deductible, help the employee pre fund that deductible, than it is to pay for an old style PPO-type plan.
Click here to listen to PART TWO of the interview.
Click here to listen to PART THREE of the interview.
