Medicare: Who Bears The Risk?

What is the principal difference between a traditional pension plan and a contemporary IRA, 401(k), or 403(b) retirement account? For a senior citizen in the United States, the difference is a matter of the placement of risk.

In both situations, someone contributes a target amount of funds each year into his investment account. He then hopes to manage those investments in a manner that will produce sufficient returns to pay himself (or his retirees) a target amount of benefits in the future.

But what if the actual returns are insufficient to pay the target benefits? In that case, for traditional pension plans, the contributor is on the hook to make up the difference. That’s why we say that such plans are required to pay their “defined benefits.”

However, for contemporary retirement accounts, the retiree must either make up the difference or settle for less than his target amount of benefits. That’s why we say that such accounts are only expected to invest their “defined contributions.”

This distinction can help us understand what U.S. Speaker of the House Paul Ryan has in mind when he promises to convert the Medicare program into a “premium support” model. At the moment, Medicare is primarily a defined benefit plan, with the government required to spend whatever is required (beyond a relatively small retiree contribution) to pay for a target level of medical benefits.

If Speaker Ryan has his way, though, Medicare will become a defined contribution plan. The government will contribute a target amount of funds to care for each senior citizen, but if the cost of medical benefits exceeds a senior’s contribution, the citizen will need to make up the difference or go without care.

Ryan calls this approach a “premium support” model because each senior citizen is responsible for financing the cost of his own medical care. Although Ryan’s proposed government program will offer a target amount of financial support to make the premium (i.e. the cost) more affordable, there will be no guarantee that this support will cover the full costs of care.

Thus, both traditional pension plans and the current Medicare program assign the risk of investment shortfalls to plan sponsors or the federal government. Under most circumstances, as long as these entities remain solvent, a retiree will bear no risk of possessing insufficient funds to meet his needs.

However, both contemporary retirement accounts and Ryan’s proposed new Medicare program assign the risk of investment shortfalls to senior citizens. Whether or not employers and the federal government remain solvent, a retiree will bear the full risk of possessing insufficient funds.

Is that fair to the retirees? For many of us, the question is a moot one in the investment industry. After all, many have already gravitated into contemporary retirement plans.

But for almost all American retirees, the question is a critical one in the health care industry. Speaker Ryan has not yet attempted to implement his plans, and a concerted effort to lobby (for or against) his proposal may result in the preservation or extinction of the existing Medicare program.

401(k) Flows: From Boomers To Millennials

The American economy seems to be moving in two different directions, doesn’t it? On the one hand, in industries like consumer technology and energy production, it continues to achieve ever more impressive levels of global success. But on the other hand, in sector after sector, it’s been ceding its “world’s largest market” status to China.

Not all of its bi-directional activity is global in nature, though; some is strictly domestic. Last week, for instance, the retirement investment industry was abuzz with the news that outflows from 401(k) retirement accounts are finally exceeding inflows on a continuing basis.

The reason? 401(k) accounts were first established to help the baby boom generation accumulate savings for retirement. And boomers, on schedule, are finally about to start retiring in large numbers.

That means that the American macro-economy is about to start experiencing a massive aggregate shift from “saving for the future” to “spending for today.” How will that affect our society?

Well, as money is withdrawn from well diversified stock and bond retirement funds, the financial markets might slump a bit. But as that money is spent by retirees and then circulated through the economy via the multiplier effect, the markets might then rebound.

Of course, if the expenditures are primarily focused on goods and services that are demanded by retirees, other sectors of the economy may weaken. But to the extent that those retirees are withdrawing retirement savings from international (i.e outside of the United States) stock and bond markets and then spending the proceeds close to home, the American economy may reap significant benefits.

Naturally, we must also consider the impact of other demographic groups on the American economy. Many retirement asset managers, for instance, are anticipating that the millennial generation will finally leverage the benefits of a strengthening job market by settling down, getting married, buying homes, and starting families. Such activities are usually accompanied by the establishment of retirement savings plans.

Furthermore, there is always a possibility that the federal government might finally get serious about immigration reform. The legalization of millions of undocumented millennials and Generation X’ers in the United States, perhaps accompanied by expanded visa programs for additional highly trained immigrants, might create a large new pool of retirement investors.

Which of these factors will prove to be most significant? Who knows? Clearly, we should be skeptical about any one who claims to be able to predict the future of the financial markets. Although it’s easy to understand why the emerging net outflow from 401(k) funds might serve as a depressive force on the investment markets, there are many other factors that might counteract its effect.

In fact, the only thing we know with absolute certainty is that the baby boom generation will inevitably continue to pass the economic baton to successor generations.  And the future of the American economy will increasingly depend on the talents, skills, and abilities of those future generations to navigate the challenges that confront them.