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Medicare Financing

The Status of the Medicare Part A and Part B Trust Funds: The Trustees' 2003 Annual Report

Research Report

Craig Caplan, AARP Public Policy Institute

Ryan Cool, AARP Public Policy Institute

March 2003


Table of Contents:

I. Introduction

Financial transactions of the Medicare program operate through two trust funds. The Federal Hospital Insurance (HI) Trust Fund finances Medicare Part A, which covers inpatient hospital, home health,1 skilled nursing facility, psychiatric hospital, and hospice care services. The Federal Supplementary Medical Insurance (SMI) Trust Fund finances Part B, which covers physician visits, outpatient services, some mental health services, durable medical equipment, some preventive services, and home health visits not covered under Part A.2 This Data Digest summarizes the current and projected financial status of these trust funds, as determined by the Trustees in their year 2003 report to Congress.3

The Trustees assess the status of each trust fund under three scenarios (high cost, intermediate, and low cost), each of which uses different sets of assumptions about such factors as general inflation, health care cost growth, wage growth, and mortality and fertility rates. Unless otherwise noted, the information presented in this Data Digest represents the Trustees' intermediate estimates, commonly referred to as the actuaries' "best guess."4

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II. The Federal Hospital Insurance (HI) Trust Fund—Medicare Part A

The Medicare Board of Trustees examines the HI Trust Fund's financial health by comparing its projected income with its projected expenditures. The primary source of income for the Part A Trust Fund is a 2.9 percent payroll tax paid by employers and employees (1.45 percent each). Self-employed individuals pay 2.9 percent of total wages.5

The Trustees report that the HI Trust Fund's annual income in 2002 exceeded annual spending for Part A services by $26.1 billion. Total expenditures were $152.5 billion, and total income (from payroll taxes and other sources) was $178.6 billion. On December 31, 2002, the HI Trust Fund's assets stood at $234.8 billion. These trust fund assets are invested in U.S. Government securities, which earned an average rate of interest of 6.5 percent in 2002.

Short-Term Financial Status

To test the short-term financial health of the HI Trust Fund, the Trustees examine the ratio of trust fund assets at the beginning of the year to expenditures during the year. For 2002, the ratio of assets to expenditures was 137 percent, which means that trust fund assets exceeded expenditures by 37 percent. If this ratio remains at or above 100 percent each year over the 10-year projection period (2003-2012), then the HI Trust Fund meets the short-range test of financial adequacy. The Trustees project that the ratio will continue to exceed 100 percent through 2012, so the trust fund passes the short-term financial test.

HI Trust Fund Solvency

The Trustees project that HI Trust Fund assets will increase through 2017, but, beginning in 2018, annual expenditures will exceed annual income, thereby reducing and ultimately depleting the trust fund reserves in 2026. Starting in 2026, Part A will no longer be able to pay the full cost of benefits, under current policy. This date of insolvency is four years earlier than the Trustees projected in their 2002 report. Figure 1 illustrates projections of the trust fund's financial status through 2026. The earlier insolvency date is the result of significantly lower projected payroll tax income and somewhat higher projected expenditures for inpatient hospital care.

Figure 1: HI Trust Fund Balance (Calendar Year End)

Under the Trustees' high cost scenario, insolvency would occur in 2015. Under the Trustees' low cost scenario, annual trust fund income would exceed expenditures for at least the next 75 years.

Long-Term Financial Status

The Trustees also look at the financial health of the HI Trust Fund for the next 25, 50, and 75 years. For this long-term analysis, tax income and costs are expressed as a percentage of taxable payroll (hereafter referred to as the income rate and cost rate, respectively).

In contrast to their favorable short-term financial outlook, the Trustees project a substantial gap between the income and cost rates for the long term (see Figure 2). The income rate will remain virtually constant over the next 75 years, while the cost rate is expected to increase over time from 2.96 percent of employment earnings subject to the HI tax in 2002 to 11.19 percent in 2075.

Figure 2: Projected Cost and Income Rates of HI Program

To test the long-range financial health of the HI Trust Fund, the Trustees examine its actuarial balance, which is the difference between the income rate and cost rate, each summarized over a given time period (i.e., 25, 50, or 75 years). A negative actuarial balance indicates a cumulative deficit and fails the Trustees' test for long-range financial health.

The Trustees project that, over a 75-year period, the Part A Trust Fund will have an actuarial balance deficit of 2.40 percent of taxable payroll. To demonstrate the magnitude of this deficit, the Trustees project that correcting the financial imbalance would require immediately either increasing the payroll tax from its current level of 2.90 percent to 5.30 percent, enacting a 42 percent reduction in Part A benefits, or implementing some combination of a payroll tax increase and Part A benefit reductions. This deficit suggests that the program fails by a large margin to meet the Trustees' long-range test of close actuarial balance.

Under the low cost scenario, the HI Trust Fund has a small actuarial deficit of 0.04 over the next 75 years. By contrast, under the high cost scenario, the cost rate is over three times the income rate during this time period, and the actuarial deficit is 7.28 percent. The vast differences in these projections illustrate the uncertainty of predicting future spending as well as accounting for economic and demographic changes. In addition to rising health care costs relative to wage growth, the ratio of workers paying payroll taxes to the number of beneficiaries will steadily decline as baby boomers become eligible for Medicare, life expectancy continues to improve, and future birth rates stay at similar levels as the last two decades. While there were almost 4 workers paying for each beneficiary's Part A benefits in 2002, there will be only 2.4 workers per beneficiary in 2030 when all of the baby boomers will have reached age 65, and 2 workers per beneficiary in 2077.

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III. The Federal Supplementary Medical Insurance (SMI) Trust Fund—Medicare Part B

The Medicare Board of Trustees does not assess the SMI Trust Fund's financial health in the same manner as it does the HI Trust Fund because of key differences in how the two trust funds operate. Income to the SMI Trust Fund comes primarily from federal general revenues and beneficiary premiums. General revenues finance about 75 percent of program spending, while beneficiary premiums cover about 25 percent.

Similar to Part A, SMI income and benefit payments are funneled through its Trust Fund. However, in the SMI Trust Fund, income from the federal government is adjusted each year to ensure that all expenses are covered. Therefore, by statute, the SMI Trust Fund can never be depleted, unlike the HI Trust Fund. Also, SMI income requirements are calculated each year to match the expected program costs for the following year, which results in fluctuations in the SMI Trust Fund reserves, depending on the difference between estimated spending and actual experience.

The Trustees report that, in 2002, expenditures from the SMI Trust Fund were $113.2 billion. Federal general revenues accounted for approximately 73.8 percent of the income to the SMI Trust Fund, and premiums covered 23.6 percent. Interest and other miscellaneous income paid the remaining 2.6 percent. As of December 31, 2002, the balance of the SMI Trust Fund was $34.3 billion.

Short-Term and Long-Term Financial Status

The Trustees estimate Part B expenditures over the next decade to be higher than those projected in the 2002 annual report, in large part as a result of the enactment of the Consolidated Appropriations Resolution of 2003, which increased physician payments. Additionally, actual Part B expenditures in 2002 were somewhat higher than had been forecasted.

While the Trustees report that the SMI Trust Fund will remain adequately financed into the indefinite future because of the automatic yearly financing from the government and beneficiaries, they express concern about the rate of growth of Part B spending. In 2002, SMI benefits increased by 11.3 percent, a rapid increase largely due to the Balanced Budget Act of 1997 (BBA) , the Balanced Budget Refinement Act of 1999 (BBRA), and the Medicare, Medicaid, and SCHIP Benefits Improvement and Protection Act of 2000 (BIPA). In particular, more than half of home health care services were reclassified as Part B services. The Trustees expect Part B benefits to increase at about 7.1 percent annually through 2012 (see Figure 3), which is faster than the growth for the economy as a whole (as measured by Gross Domestic Product or GDP).

Figure 3: Projected Growth in SMI Spending and in GDP, 2002-2012

The Trustees predict that Part B spending will grow rapidly over the next decade and beyond, in part because of increases in the volume and intensity of services provided per beneficiary. Starting in about 2011, the influx of baby boomers will also greatly increase spending, as will continued improvements in life expectancy and future birth rates that stay at levels similar to those of the past two decades.

The Trustees also calculate Part B expenditures as a percentage of GDP in order to examine the potential impact of program spending growth on the economy. From 1966 through 2001, Part B expenditures were less than 1 percent of GDP. SMI expenditures were almost 1.1 percent of GDP in 2002, and are projected to reach 2.3 percent of GDP in 2030 and 4.2 percent of GDP by 2077. Such a trend means that Part B expenditures can be expected to consume growing shares of our country's productivity.

Under the Trustees' high cost assumptions, Part B spending would grow much more rapidly than GDP beyond 2012. Under the Trustees' low cost assumptions, expenditures would initially increase at about the same rate as GDP, then grow faster than GDP.

Impact on Beneficiaries and on Taxpayers

Because Part B per capita spending is expected to grow faster than per capita GDP, beneficiaries would see increases in premiums over time. The Trustees estimate that, in 2002, about 6.8 percent of a typical 65-year-old beneficiary's Social Security benefit was withheld to pay the monthly Medicare Part B premium of $54, and 8.9 percent was used to pay Part B copayments, for a total of 15.7 percent. In 20 years, under the intermediate assumptions, 22.9 percent of the same beneficiary's Social Security benefit would need to be withheld for Part B premium and copayments. By 2070, these out-of-pocket expenses will consume 36.1 percent of the average 65-year-old's Social Security benefit.

In fiscal year 2002, the general revenues required to cover Part B expenditures were equivalent to 7.8 percent of the total federal personal and corporate income taxes collected in that year. The Trustees project that, in 2070, if these taxes remain at their current level relative to the national economy, the federal general revenues needed to finance SMI expenditures would equal about 30 percent of total income taxes.

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IV. The Medicare HI and SMI Programs Combined

The Trustees also examine the financial status of the Medicare program as a whole (i.e., both Part A and Part B). The Trustees state that people tend to focus primarily on the financial status of the HI Trust Fund and place less emphasis on the SMI Trust Fund, due in large part to the different means by which the two programs are financed. The HI program is financed through statutory tax rates that can only be adjusted through legislation. By contrast, SMI general revenue financing and beneficiary premiums are reestablished annually to match the expected program costs for the following year. Because of these fundamental differences, less attention is given to spending growth and financing requirements of Part B.

In 2002, Medicare expenditures accounted for about 2.6 percent of GDP. The Trustees project that, under current law, the HI and SMI programs combined will increase to about 5.3 percent of GDP by 2035 and to 9.3 percent of GDP by 2077. The Trustees acknowledge, however, that projecting so far into the future is difficult given the vast uncertainties.

V. Trustees' Conclusions

Although the short-term financial status of the HI Trust Fund remains favorable, the Trustees now project that the HI Trust Fund will become insolvent in 2026, 4 years earlier than projected in their 2002 annual report. This earlier insolvency date is the result of significantly lower projected payroll tax income and somewhat higher expenditures for inpatient hospital care. Additionally, the Trustees note that the Fund's long-term financial status remains problematic.

By design, the SMI Trust Fund is financially solvent into the indefinite future. However, the Trustees remain concerned about the growth rate of SMI spending, which continues to increase faster than GDP.

The Trustees believe that solutions should be found in the near future to ensure the financial integrity of the HI program and to provide effective means to control Medicare costs. Further, they state that effective and decisive action is necessary to build upon the steps already taken.


Footnotes

1 Medicare Part A covers up to 100 home health visits following a hospital stay of at least three days.
2 Part B covers home health visits not preceded by a hospital stay and visits over the 100-day Part A limit.
3 Through 2001, the Boards of Trustees issued separate annual reports for the HI and SMI Trust Funds. Starting in 2002, the two reports were combined into one document.
4 Unless otherwise noted, all figures are calendar year estimates.
5 In 2002, payroll taxes made up 85.5 percent of the HI Trust Fund's income. Additional sources of income include interest on federal securities, a portion of federal income taxes on Social Security benefits, premiums paid by voluntary enrollees, and government credits.
6 Alternatively, if the Trust Fund ratio is initially less than 100 percent, it must be projected to reach a level of at least 100 percent within 5 years and then remain at or above 100 percent throughout the remainder of the 10-year period. (The Trust Fund assets may not fall to zero.)
7 Tax income to the HI Trust Fund is projected to exceed total expenditures each year through 2012. Thus, beginning in 2013, annual expenditures from the trust fund will exceed annual income from taxes. However, trust fund assets are projected to continue growing each year through 2017 because total income to the trust fund-which includes interest on U.S. Government securities-will still exceed total expenditures each year between 2013 and 2017.
8 The actuarial balance is adjusted to include the beginning fund balance and the cost of ending the projection period with a fund balance equal to estimated spending for the following year.
9 Readers should use caution when comparing these projections to those prior to year 2001, at which time the Trustees revised their assumptions about long-range expenditure growth. See PPI data digest #59 for an explanation of how and why the Trustees made these changes.
10 The premium rates between 1998 and 2003 are intentionally set to cover less than 25 percent of actual program costs, due to the gradual phase-in of the transfer of some home health costs from Part A to Part B.
11 The BBA reduced payments to hospitals, established new payment methodologies for home health agencies and skilled nursing facilities, and shifted certain home health costs from Part A to Part B. The BBA also established the Part B premium at about 25 percent of expenditures.

Sources

2003 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, March 17, 2003;

unpublished 2002 and 2003 projections from CMS, Office of the Actuary;

and 2003 CBO economic projections.


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Written by Craig Caplan and Ryan Cool, AARP Public Policy Institute
March 2003
©2003 AARP
May be copied only for noncommercial purposes and with attribution; permission required for all other purposes.
Public Policy Institute, AARP, 601 E Street, NW, Washington, DC 20049

Pub ID: DD87