Ch8. Public Pensions and Health Insurance Economics

Why Public Pension Systems Exist

If private insurance markets function, why should government run a mandatory public pension program?

Reason 1: Adverse Selection

In a voluntary private annuity market, only those who expect to live longer purchase annuities → adverse selection drives up premiums and can unravel the market
Mandatory enrollment eliminates adverse selection by pooling all workers

Reason 2: Myopia / Present Bias

Individuals systematically undersave for retirement (present-consumption bias)
Mandatory saving through Social Security ensures minimum retirement income

Reason 3: Incomplete Private Annuity Markets

Private lifetime-income products are thin because of longevity risk and adverse selection
A public system steps in where private markets fail to provide affordable annuities

Two Pension Financing Designs

Pay-As-You-Go (PAYG)

Structure: Current workers’ payroll taxes → fund current retirees’ benefits

Advantages	Disadvantages
Works well when the workforce is growing	Vulnerable to population aging and declining worker-to-retiree ratios
Does not require pre-existing capital stock	Intergenerational transfer — tomorrow’s workers bear the cost
Easy to launch (initial retirees receive benefits without having contributed)	Implicit return capped by economic growth rate

Implicit return in PAYG: The expected real return ≈ labor force growth rate + real wage growth rate (Aaron condition)

Fully Funded (FF)

Structure: Each worker’s contributions are invested and accumulate → benefits paid from individual accounts

Advantages	Disadvantages
Less sensitive to demographic shifts	Transition cost: during switchover, one generation must finance both old PAYG retirees and their own accounts
Can earn capital market returns	Investment risk borne by individuals
Generationally independent	High start-up costs

Social Security (OASDI) is primarily PAYG in structure, financed by a 12.4% payroll tax (split evenly between employer and employee). The Social Security trust funds hold a partial reserve that supplements current tax receipts, giving it a hybrid character — but the reserves are expected to be depleted in the early 2030s under current projections, which would trigger automatic benefit cuts absent legislative action.

Population Aging and Pension Finance

PAYG fiscal balance condition:

Outlays  = number of beneficiaries × average benefit
Revenues = number of workers × average payroll tax contribution

As the old-age dependency ratio (retirees per worker) rises, the system faces chronic deficits.

US demographic trends:

Baby Boomer cohort (born 1946–1964) is now fully in retirement
2023 ratio: roughly 3 workers per Social Security beneficiary, down from 16:1 in 1950
CBO projects rising deficits after trust fund depletion in the 2030s

Paths to Social Security reform:

Raise payroll tax rate: Increases revenue — larger burden on current workers
Cut benefits or slow cost-of-living adjustments (COLAs): Reduces outlays — adverse for current/future beneficiaries
Raise the full retirement age (FRA): The 1983 Greenspan Commission reforms raised FRA from 65 to 67 (phased in by 2027); further increases are debated
Adjust the benefit formula: Change the Primary Insurance Amount (PIA) bend points to reduce replacement rates for higher earners

Social Security is not merely a savings program — it redistributes income across earnings levels.

Benefit formula:

The PIA formula applies three successive replacement rates to Average Indexed Monthly Earnings (AIME): ~90% on the lowest earnings tier, 32% on the middle tier, and 15% on the upper tier
Low-income workers receive a higher replacement rate relative to their earnings (progressive structure)
Higher earners receive larger absolute benefits but lower replacement rates

Replacement rate: benefit as a percentage of pre-retirement earnings

Average US worker: roughly 40% replacement rate from Social Security alone
Social Security was designed as one leg of a “three-legged stool” (Social Security + employer pension/401(k) + personal savings)

Health Insurance Economics

Special Features of Health Care Markets

Health care markets differ from standard competitive markets:

Feature	Description
Information asymmetry	Providers know far more than patients about diagnosis and treatment necessity
Uncertainty	Illness is unpredictable in timing and severity
Positive externalities	Vaccination and infectious-disease treatment generate broad social benefits
Non-profit character	Many hospitals and insurers are nonprofit; profit motive may distort care
Adverse selection	Sicker individuals disproportionately seek coverage, raising premiums and potentially unraveling voluntary markets

These features justify public intervention — through Medicare, Medicaid, the ACA, and insurance regulation.

Adverse Selection in Health Insurance

Voluntary private health insurance markets can break down:

Sicker/higher-risk individuals buy coverage; healthier individuals opt out → premium spiral → “death spiral”
The Affordable Care Act (ACA) addressed this through: individual mandate (weakened to $0 penalty after 2019), community rating requirements, guaranteed issue, risk-corridor and reinsurance programs

Public insurance (Medicare/Medicaid) solves adverse selection via universal or near-universal enrollment — risk pooling is broad.

Moral Hazard in Health Insurance

Once insured, individuals consume more health care than they would at full cost:

Types of moral hazard:

Ex post moral hazard: Lower out-of-pocket cost → over-utilization of care (too many ER visits, elective procedures)
Ex ante moral hazard: Having insurance reduces investment in preventive health behaviors

Mitigation tools:

Cost-sharing: deductibles, copays, coinsurance — patients face some marginal cost
Prior authorization: insurer review of costly procedures
Health Savings Accounts (HSAs) paired with high-deductible plans

The RAND Health Insurance Experiment

The landmark RAND HIE (1970s–80s) randomly assigned households to plans with varying cost-sharing:

Higher cost-sharing reduced health care utilization significantly
For most participants, reduced utilization did not worsen health outcomes
Exception: low-income individuals with serious conditions experienced worse outcomes when cost-sharing was high

Implication: A portion of health care consumption is discretionary and can be reduced by cost-sharing without large health effects — but safety-net protections matter for vulnerable populations.

Supplier-Induced Demand

Supplier-induced demand (SID): Providers recommend services beyond the patient’s uninformed demand to boost their own revenue.

Fee-for-service (FFS) reimbursement: each procedure billed separately → financial incentive to do more tests, procedures, and referrals
Evidence in the US: geographic variation in Medicare spending with little variation in outcomes (Dartmouth Atlas of Health Care)

Payment reforms to address SID:

Method	Mechanism	Trade-off
Diagnosis-Related Groups (DRGs)	Fixed payment per hospital admission by diagnosis — used in Medicare since 1983	Reduces over-treatment but creates incentive to under-treat or discharge early
Capitation	Fixed per-member-per-month payment regardless of services used	Reduces over-utilization; risk of under-service
Bundled payments	Single payment for an episode of care	Aligns incentives across care team; complex to implement
Pay-for-performance (P4P)	Bonuses tied to quality metrics and outcomes	Encourages preventive care; metric gaming risk

Health Care Cost Sustainability

Drivers of health care cost growth in the US:

Aging population: Medicare spending per capita rises steeply with age; the 65+ population is the fastest-growing
Technological change: New drugs, devices, and imaging that improve outcomes but add cost (Baumol cost disease also applies)
Administrative complexity: The multi-payer system generates high billing and compliance costs (estimates: 25–35% of US health spending is administrative)
Income growth: Health care is a normal/luxury good; as incomes rise, demand increases

US health expenditure context:

US spends ~17% of GDP on health care — roughly twice the OECD average
Despite high spending, outcomes (life expectancy, infant mortality) lag behind peer countries on many measures
Medicare and Medicaid together account for ~40% of all national health expenditures

Policy levers for cost containment:

Payment reform: Shift from FFS to value-based models (DRGs, capitation, ACOs)
Benefit design: Higher cost-sharing to reduce moral hazard (with protection for low-income enrollees)
Preventive care investment: Reduce downstream costs of chronic disease
Drug price negotiation: The Inflation Reduction Act (2022) gave Medicare authority to negotiate prices on select high-cost drugs for the first time

Frequently Tested Concepts

PAYG vs. Fully Funded:

PAYG: current workers → current retirees; implicit return = wage + population growth; vulnerable to aging
Fully funded: individual accounts invested in capital markets; generationally independent

Social Security redistribution:

Progressive PIA bend-point formula: low earners get higher replacement rates; higher earners get higher absolute benefits but lower replacement rates

Health market failures:

Information asymmetry + adverse selection + moral hazard coexist in the same market

Supplier-induced demand:

FFS → over-utilization → addressed by DRGs, capitation, and bundled payments

Study Checklist

Explain the three rationales for mandatory public pension systems
Compare PAYG and fully funded designs — advantages, disadvantages, and the transition cost problem
Describe how population aging affects PAYG fiscal balance and the policy options for reform
Explain adverse selection and moral hazard in health insurance and how they are addressed
Describe supplier-induced demand and how DRGs and capitation address it
Identify the main drivers of US health care cost growth and key policy responses

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