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Medicare Out-of-Pocket Costs: Can Private Savings Incentives Solve the Problem?

Medicare Man

Medicare's benefit structure leaves beneficiaries with significant out-of-pocket costs, particularly if they lack supplemental coverage. Out-of-pocket costs disproportionately affect low-income, old, and chronically ill Medicare beneficiaries: in 2003, the elderly with incomes under 135 percent of federal poverty level (FPL) spent one-third of their income on uncovered medical care, on average. Individuals of all incomes with fair or poor health status or age 85 and older spent almost 30 percent. (The 2007 Federal Poverty Level for a non-elderly adult is $10,787, and it is $9,944 for an elderly adult.) Although Medicare added an outpatient prescription drug benefit in 2006, poor and sick beneficiaries still face a substantial cost burden.

Supplemental coverage is a way to offset Medicare's cost-sharing requirements, but it is itself typically a significant expense. The poor, ill, and "oldest old"—that is, the same populations that face the highest out-of-pocket expenses—have particularly poor access to Medicare supplemental coverage. Low-income individuals disproportionately lack retiree benefits from former employers and typically cannot afford Medigap premiums, while the oldest old and those with chronic conditions will often be turned down for affordable Medigap coverage and may hesitate to enroll in managed care plans because of their more acute need for access to specific providers. Lack of supplemental coverage is associated with reduced access to care: beneficiaries without such coverage are less likely to have a physician as a regular source of care, more likely to delay care because of cost, and less likely to receive standard preventive care. Uncovered long-term care costs also have significant negative effects on many Medicare beneficiaries and their families. The great majority of Medicare beneficiaries must rely on their own income and savings to pay for long-term in-home assistance. Nursing home costs are also a major medical burden for Medicare beneficiaries. While Medicaid guarantees virtually universal access to nursing home care, Medicaid eligibility imposes catastrophic financial costs on many Medicare beneficiaries.

As a possible solution to the out-of-pocket cost burden on the elderly, incentives for private saving have considerable appeal. Recent proposals from both parties in related policy areas have centered on tax incentives for saving during working-age years, including Health Savings Accounts and subsidized or tax-advantaged long-term care insurance. Private savings may seem to be the most realistic path for doing something to address the growing problem of post-retirement medical expenses, particularly given competing budget priorities such as the Medicare drug benefit and the renewed focus on the nonelderly uninsured.

This report analyzes the extent to which incentives to save could offer significant relief of post-retirement healthcare costs. We analyze this with a particular focus on low-income participants as part of a broader analysis of families of varying income levels. We include projections of savings potential for individuals of varying income levels if they could save a modest percentage of their income tax free and receive a rate of return equivalent to that in a basket of U.S. Treasury bonds. (We provide the main findings from this analysis in the body of the report as well as more detailed charts and tables in Appendices A and B.) We also add an analysis of the potential impact of a moderately sized government match for low-income beneficiaries, using the Earned Income Tax Credit as a rough guide for potential subsidy levels. We look at current IRA/401(k) participation by income level both to project possible participation rates in an incentivized savings program and to examine the impact of matching subsidies on low-income participation.

Several key analytical conclusions emerge from this discussion.
  • The problem of uncovered out-of-pocket costs is predominantly a problem of low-income individuals. Low-income seniors actually have lower medical costs on average than other seniors, but they have far fewer cash and insurance resources to apply to them. Medicare beneficiaries with an income less than 135 percent FPL spend 33 percent of their annual income on out-of-pocket health care costs, on average, while those above 200 percent FPL spend only 12 percent.
  • Enhanced savings offer only a partial solution to this problem for low-income seniors. Even with a matching subsidy, low-income individuals who saved 1 percent of their income tax free from age 50 on would on average save enough to pay for about a year of Medigap for poor and near-poor seniors (incomes under 150% FPL), and three years of Medigap for lower-middle-income seniors. Because their preretirement incomes are low on average, helping low-income individuals to save will not fully address the problem of out-of pocket medical costs for the low-income elderly. Nevertheless, particularly given the low savings levels of the poor and near poor, savings on the order of 1 percent of income could make a real difference in relative terms.
  • A policy allowing near-retirees to save for post-retirement medical expenses tax free is likely to appeal to both low-income and higher-income individuals. Low-income and lower-middle-income populations do participate in appreciable numbers in tax-advantaged retirement savings in their 50s and 60s, while higher income populations participate in these programs at higher rates. If patterns from other savings incentives programs would hold for a similar program targeted at medical costs, between 20 percent and 40 percent of low-income people would participate, with participation on the higher end of that range among those with incomes between 150 percent and 300 percent FPL. There is evidence that a public matching subsidy would be a critical element to attracting low-income participation. Participation rates for individuals with average and higher incomes are likely to be 50 percent or more.
  • There is a strong fiscal case for partly or totally limiting any tax incentives for post-retirement medical costs to low-income and lower-middle-income individuals. The policy problem of uncovered post-retirement medical costs is far more acute in this population. A universal option to save a percentage of income for post-retirement medical costs tax free would cost $18 in lost tax revenue for every dollar saved. In contrast, allowing only those with incomes of 300 percent FPL or less to shelter savings from taxation would reduce the tax revenue loss to the federal budget to $8 of every $100 saved. A more modest form of means testing would allow tax incentives to apply almost universally but still reduce costs: applying the Alternate Minimum Tax (AMT) to income saved and denying eligibility for the highest 3 percent of earners who do not pay the AMT would reduce the percentage of total income potentially subject to sheltering by about 38 percent, and would reduce budgetary impacts by close to 50 percent.

Publication Details



E. Fishman, S. Tamang, and D. Shea, Medicare Out-of-Pocket Costs: Can Private Savings Incentives Solve the Problem?, The Commonwealth Fund, March 2008.