Introduction
Healthcare expenditure in the United States is rising at a faster rate than overall inflation. National health expenditures are projected to reach $3.6 trillion in 2014, growing at an average annual rate of 7.1 percent during the forecast period 2003-2014. As a share of gross domestic product (GDP), health spending is projected to reach 18.7 percent by 2014, up from its 2003 level of 15.3 percent (Heffler, 2005). With the Obama administration looking at socialized medicine, we thought it important to explain a far better option that is already in place.
Health Savings Accounts (HSAs) were created by Public Law 108-173, the "Medicare Prescription Drug, Improvement and Modernization Act of 2003," signed into law by President Bush on December 8, 2003 (US Treasury Department, 2005). HSAs are designed to help individuals take more control over how their health care dollars are spent and save for future medical and retiree health expenses on a tax-free basis. At a time when health care costs are rising rapidly and individuals, families and employers are struggling to find lower-cost alternatives, HSAs may serve as a vehicle to reduce costs and offer more control to the individual on how their healthcare dollars are spent. In fact, HSAs were designed by the legislation to offer the insured more advantages than previous plans in order to enable them to take control of their own healthcare (See Exhibit 1). We have explained the features of this vehicle in the following paragraphs.
Salient Features of Health Savings Accounts
Any adult who is covered by a high-deductible health plan (HDHP), and has no other first-dollar or traditional health care coverage, may establish an HSA. Tax-advantaged contributions can be made in three ways:
- an individual or family can make tax deductible contributions to the HSA even if they do not itemize deductions;
- an individual’s employer can make contributions that are not taxed to either the employer or the employee;
- Employer sponsored cafeteria plans allow employees to contribute untaxed salary through salary reduction.
How HSAs Work
HSAs allow individuals and employers to make deposits each year equal to their health insurance deductible. The HDHP that accompanies an HSA must have an overall deductible of at least $1,000 for an individual or $2,000 for a family policy. A typical plan can be described as follows. When an individual enters the medical marketplace, they will spend first from their HSA. If they exhaust their HSA funds before reaching the deductible, they will then pay out-of-pocket. Once they reach their deductible, the HDHP will absorb the additional cost.
For the 2009 tax year, annual HSA deposits cannot exceed $3,000 for individuals and $5,950 for families. These account balances may earn interest or be invested in stocks or mutual funds, and all earnings will accrue tax free. Therefore, a young adult worker, at retirement, may have hundreds of thousands of dollars available to spend for medical related expenses. As noted below, the projected cost of medical spending at retirement is extremely high in today’s dollars.
HSA balances belong to the individual account holders and are portable should the employee switch jobs, become unemployed or retire. The funds can be used to pay expenses not covered by insurance, insurance premiums while unemployed and health expenses during retirement. In the event of death, HSAs may be bequeathed to a spouse, or (like an IRA) the funds may flow to other heirs.
Next, let’s examine the compatibility of the HSA legislation with commonly known economic principles.
Analysis of HSA Legislation vis-à-vis Economic Principles
- How people make decisions
- How the economy works as a whole, and
- How people interact.
How People Make Decisions
Principle 1: People Face Tradeoffs. To get one thing, you have to give up something else. Making decisions requires trading off one goal against another.
Analysis of the HSA Legislation
HDHP in conjunction with the HSA allow the insured to pay a lower insurance premium in exchange for a higher deductible. The implied risk is that the individual will not be able to pay the high deductible in the event of a medical expense. With the HSA’s tax incentives, the insured’s risk is mitigated by their ability to use pre-tax dollars to pay for the high deductible. As an example, if an insured’s annual deductible in a HDHP is $1,000 and the insured had previously been paying a $100 deductible using after tax dollars, the difference of $900 (assuming an individual tax rate of 28%) costs the insured $648 of incremental dollars.
An additional risk is the possibility that short term health expenses (i.e. the deductible amount) may exceed the amount of money saved to that point in the HSA. However, once the insured is past this initial “start up” cost, the money invested in the HSA may grow tax free like other retirement vehicles. In fact, HSAs are structured to mimic many of the positive features of IRA (including the Roth IRA) and 401k accounts with the additional incentive of spending the money without incurring a tax on future health expenses. The limitation with the HSA when used as a retirement vehicle is that contributions are capped per year based on the deductible (similar to 401ks and IRAs). The tradeoff exists when the insured is faced with the choice of investing limited dollars into a traditional retirement account (especially a 401k plan with a company matching feature) versus investing these funds in an HSA that does not have a similar company matching feature, and to avoid tax at retirement must be spent on qualified medical expenses. Further, many consider the limited choices of investment options currently available to the insured for HSA accounts to be a trade off with this product. However, this is changing rapidly as Merrill Lynch, Charles Schwab, and other financial groups have designed investment accounts strictly for the HSA (Whitehouse, 2005).
One of the biggest perceived trade-offs associated with a HDHP is the elimination of coverage for preventive care including routine physical exams, screening services, certain prescription drugs as well as routine pre-natal and well-child care . With a traditional insurance plan, many of these expenses have been covered. In the HSA policy, these are also included (with a co-pay) under a safe harbor provision in the legislation which enables first dollar coverage from the HDHP instead of the insured accessing funds from their HSA (www.HSAinsider.com).
There are, however, certain medical expenses not covered by the safe harbor that would be covered by traditional low deductible plans but that will need to be funded from the insured’s HSA account under the HDHP.
Another trade off is the decision by individuals to forgo some routine medical services in the near term in exchange for the compounding effect on savings accumulated in a HSA. In this way, the individual is deciding not to incur these near term health expenses in order to save these funds for the eventual medical expenses required later in life. However, the legislation does not seem to have an adverse effect on the health of members participating in the HSA plans because if members using savings accounts were spending less on their health to their detriment, they would be getting sicker and would go to hospital more. However, statistics on the incidence of hospital use by Discovery Health members (a medical savings plan) over five years show no increase in the use of hospitals. In addition, a comparison of hospital use by a comparable membership on a traditional option and those on a medical savings account (“MSA”), shows there is generally lower hospital use by members on a savings account option (Preez, 2003).
Further, a new survey of 2,500 HDHP participants by consultants McKinsey & Co. discovered that persons who have switched from a traditional insurance plan to a HDHP have received annual check-ups, basic lab tests, prostate and breast cancer screenings at an equal or higher rate (Furhmans, 2005).
Principle 2: The Cost of Something is What You Give Up to Get It. Decision-makers have to consider both the obvious and implicit costs of their actions.
Analysis of the HSA Legislation
The insured must decide whether the maximum amount that can be contributed (and subsequently deducted) to a HSA (which is the lesser of the HDHP deductible amount or the maximum allowable [by law] contribution) is less costly than a traditional low deductible plan. When deciding, the insured must factor in all explicit and implicit (i.e. opportunity) costs including costs associated with an out of network provider, co-pay amounts with the traditional health policies, as well as participating health care providers and hospitals. We obtained, for illustrative purposes, a recent insured’s (in this case a company sponsored plan) switch from a traditional plan to a HDHP (See Exhibit 3).
This exhibit indicates that the insured’s explicit costs are less under the HDHP in the form of lower premiums. The total monthly medical premium under the HDHP is $36,172.06 or $434,065 annually. The insured’s old traditional monthly premium was $46,502.79 or $558,033 annually. The explicit savings is $123,969. However, the deductible under the new plan is $2,850 (single) and $5,600 (married) versus $2,000 and $4,000 respectively for the old plan. This implicit cost to the employee associated with a higher deducible can lead to employee morale issues and ultimately lead to defections for this 84 person group. It is the intention of the employer in our exhibit to utilize a majority of their projected health care savings from reduced premiums to fund the incremental deductible for the employee into the HSA. They have based this on their previous census data that indicate that less than 30% of the employees will reach a deductible of $1,000 – let alone $3,000 or $5,950.
In addition to the example above, there is growing evidence that suggests that health care premiums with an HDHP are lower than the traditional plans and continue to drop. For example, the monthly premium for a typical family plan in Western New York is nearly $665. The monthly premium for a HSA family plan in the same region is about $360 (Koetzle, 2005). Additionally, there are at least five insurance firms that are lowering their premiums in 2005 (Whitehouse, 2005).
We have illustrated that the explicit costs of the HDHP are not higher than the traditional insurance plans. The implicit costs of additional time required to shop around for lower healthcare prices (Furhmans, 2005), or the cost of incurring a higher deductible, we believe, are outweighed by what the insured receives in return – lower premiums coupled with strong evidence that they will continue to be reduced by the insurance carriers.
Principle 3: Rational People Think at the Margin. A rational decision-maker takes action if and only if the marginal benefit of the action exceeds the marginal cost.
Analysis of the HSA Legislation
What are the marginal benefits and costs of switching from third party insurance to a high deductible health plan and related health savings account?
Marginal Benefits
By switching to a HDHP which would enable the insured to utilize a HSA, the unused funds in the HSA belong to the insured, irrespective of changes in employment or retirement. HDHPs and HSAs are designed to be portable, so that changing jobs no longer means losing coverage. Traditional insurance plans without an HSA do not have any carryover balances. Additionally, HSA distributions can be used to pay premiums for COBRA, Medicare premiums and out of pocket expenses, other health insurance premiums for persons 65 years or persons receiving federal or state unemployment. These distributions can also be used to pay qualified long-term care insurance.
In the event of death, HSA funds may be bequeathed to a spouse, or (like an IRA) the insured’s heirs.
Additionally, as previously mentioned, there is a major tax advantage when switching to a HDHP and HSA. This is due to the ability to deduct HSA contributions above adjusted gross income (similar to an IRA, SEP or 401k). This is more advantageous than a medical deduction that exists for the taxpayer (but only if he itemizes his deductions), which is further subject to a deduction floor. For example, if a family with adjusted gross income of $100,000 incurs medical expenses of $7,000, and they itemize their deductions, they would not be entitled to a deduction due to the fact that they have not reached the floor of 7.5% of adjusted gross income – or $7,500.
Under the HSA, the first $5,250 of expense is deducted from their adjusted gross income. Thus, the family (filing jointly) would realize a tax savings under the HSA scenario of approximately $1,300 (See Exhibit 4).
Marginal Costs
Out-of pocket expenses if savings in HSAs are not adequate to cover the deductible expenses. This problem can occur during the initial phase of establishing the HSA account. However, as we demonstrated above, the cost savings for many employers of switching to a HSA from traditional insurance may be adequate enough to fund the entire deductible amount for their employees.
Another marginal cost is the insured’s inability to employ the disposable income for alternate use. In other words, if an insured enrolls in a HDHP, this requires that significant funds be placed in an HSA as previously discussed.
With the required switch to a high deductible program, the insured and his family may not have access to the same health care network that they have used under the traditional insurance plan. This can cause inconvenience and discomfort for them.
Principle 4: People Respond to Incentives. Behavior changes when costs or benefits change.
Analysis of the HSA Legislation
The marginal benefits and costs were outlined in principle 3 and we believe that the benefits outweigh the related costs, which provides people with sufficient incentive to change. Moreover, the tax benefits and tax free growth of money left in an HSA provides the participant with incentive to live a healthier lifestyle and avoid doctor’s visits and medical expenses.
Furthermore, patients will choose low-cost options in healthcare like generic drugs over brand names helping drive healthcare costs lower. Nearly half of per capita health care expenditure during a lifetime occurs during senior years with the remaining during childhood and middle years (Alemayehu, 2004). Thus, if HSAs are implemented during one’s early years, incentives are in place for overall per capita health care expenditures to be reduced which could potentially reduce the expected growth in health care expenditures back in line with inflationary growth observed in other sectors of our economy.
The traditional low deductible insurance program with its low co-payment, does not provide adequate incentives to stay out of the doctor’s office (and arguably may encourage frequent doctor visits). However, with a HSA plan, an individual or family, if they stay healthy, may accumulate between two to four hundred thousand tax free dollars, respectively, at retirement which can then be withdrawn, tax free, for subsequent medical expenses. This assumes a modest annual interest rate of 5% over thirty years. According to a recent study by Fidelity Investments (Ruffenach, 2005), a 65-year-old couple retiring today, with no employer-sponsored retiree health coverage, would need about $190,000 to pay medical bills (including Medicare premiums, drug costs and other expenses) during the next 15 to 20 years. The HSA provides a young couple with sufficient incentive to prepare for this sobering statistic. Finally, providers of healthcare now have incentives to charge lower fees if they know that cash payments will be made from the HSA account without the hassle and paper work costs associated with billing for services to traditional insurance. We believe HSAs provide enough incentives, both for the consumer and provider of healthcare, to facilitate a reduction of healthcare costs in this country’s economy.
How the Economy Works as a Whole
Analysis of the HSA Legislation
Adam Smith’s “invisible hand” suggests that when everyone is promoting self-interest within a society, prices automatically adjust according to the law of supply and demand and overall societal interests are maximized. With traditional insurance, pricing has been set by insurance companies, who bundle their buying power in an effort to control some of the costs associated with health care. Although these companies are promoting the self-interest of their firms, the input of the insured is typically negated which leads to less-than-optimal societal conditions. HSAs provide the insured with the ability to weigh the benefits of spending on health care against the costs.
HSAs introduce market activity that is only present in limited amounts with traditional insurance. This is due to the relative number of individuals negotiating health care costs with HSAs versus the traditional insurance pools. Many people are already abandoning insurance pools because traditional insurance has become too expensive (Cannon, 2003). The Census Bureau estimates that from 2000 to 2001, the number of uninsured Americans with annual household incomes above $75,000 grew by one million, making them the fastest growing uninsured population. The Center for Studying Health System Change reports one-fifth of uninsured workers are offered - but decline - employer coverage, and two-thirds say cost is the reason. HSAs and the HDHP may help bring these people back into private insurance pools, which would make coverage more affordable to those who are not healthy and wealthy (Cannon, 2003).
HSA-type accounts seem to be a natural progression in a free market health care system, directed by the “invisible hand” to provide equilibrium to the market. An example of this natural progression is South Africa’s health care system, where they have enjoyed a free market system of health care over the last decade (Matisonn, 2000). The major problem whenever medical care is free at the point of consumption is that demand usually exceeds supply, resulting in non-price rationing. However, the introduction of the MSA, competing against other forms of insurance on a level playing field, has produced remarkable results. In a few short years, MSA plans have become increasingly popular, and they already have captured about half the market. By contrast, HMO-type managed care has made only small inroads.
Health account holders in South Africa pay an average of 11 percent less for non-chronic prescription drugs than those with traditional insurance, because health accounts encourage patients to shop and control costs. Such economizing explains why health account premiums in South Africa are growing at the same rate as income - and are declining relative to income when enrollees' savings are subtracted - while traditional health insurance premiums are rising at an increasingly faster rate than income (Cannon, 2003).
One of the arguments by the opponents of HSA is that HSA’s will promote adverse selection by attracting people who are healthier than average, thus driving up the premiums for those who are less healthy. However, a study by the National Center for Policy Analysis (Matisonn, 2000) of the South African health care system revealed the following:
- The average MSA holder spends about half as much on outpatient services plus drugs as do people in traditional plans.
- There is no evidence that MSA holders skimp on primary care in a way that leads to higher inpatient costs.
- Judged by the incidence of catastrophic claims, MSA holders are not healthier as a group than enrollees in conventional insurance plans.
- Although MSA plans appeal to people who are healthy, those who are sick and have high health care costs are also financially better off in MSA plans than in traditional insurance.
HSA accounts in the United States will force additional competition in the health care, insurance, and financial markets. In fact, the introduction of HSA’s has increased the market demand for HDHP insurance, as well as created another avenue for pre-tax health spending. The creation of HSA’s has also prompted HSA investment options by financial firms to capture the HSA assets (Whitehouse, 2005). These same financial firms, through their advisors, are encouraging HSA clients to maintain the dollars invested in HSAs (to take advantage of the tax free earnings potential) and instead to use current, non-HSA dollars for the cost of the deductibles paid each year, if necessary.
According to an article in PR Newswire, (Whitehouse, 2005), Charles Schwab partnered with Blue Cross and Blue Shield to create twelve mutual funds designed specifically for HSA savings accounts. J.P. Morgan launched a similar program with a major insurance carrier last year. These financial products, which increase the investments into the financial markets, are a prime example of the invisible hand guiding free market economies.
Although there are some differences in the South African health care system, the HSA’s in the United States will most likely adopt some of these variations as the plan grows, providing more flexibility and allowing the market rather than Congress to discover what works best. These accounts promise to revolutionize the American medical marketplace and have significant potential positive effects on the overall health care system such as:
- Health accounts help reduce the number of uninsured Americans by making coverage more affordable - for example, 73 percent of Americans with MSAs were previously uninsured, according to the Internal Revenue Service.
- Health accounts help contain medical inflation by giving consumers incentives to forgo unnecessary care and become prudent shoppers.
- Health accounts eliminate waste and bureaucracy in the health care system by giving patients a stake in the savings.
Analysis of the HSA Legislation
The inexorable rise in health care in the U.S. economy, recently estimated to increase annually by 7%, is an example of the failure of a market to allocate resources efficiently (Heffler, 2005). Health care premiums have increased to at least twice the level of the consumer price index. With the projected increase, health care costs will double in five years. One reason for these increases may be that the government has had too much control of the health care market, preventing the “invisible hand” from working effectively. In 1995, for example, forty six percent (46%) of healthcare spending was provided by the government (Federal and State Spending). Thus, the creation of HSA accounts may be viewed as the government legislating itself out of the health care market.
The government’s creation of the HSA accounts can directly mitigate the rise in health care costs. According to Mr. Andy Laperriere, Managing Director of ISI Group’s Policy Research Institute in Washington, D.C., “The first problem with [this structure] is the high administrative costs associated with having insurance companies scrutinize and reimburse routine expenses. Doctors who want to avoid insurance industry red tape pay, on average, 8% of revenue to outsource this function to a billing company. Even if insurance companies spend only a quarter of the amount doctors do on their reimbursement bureaucracies, more than 10% of the cost of a visit to the doctor -- $40 billion per year -- is wasted on paperwork. Most of these costs would disappear if patients paid for their doctor visits directly (with a debit card, for example), which would be the case for most consumers who choose high-deductible plans with a health savings account.” (Laperriere, 2005). From the economic standpoint of market forces of demand and supply, administrative costs can be viewed as input prices required to provide healthcare services. If administrative costs are reduced or eliminated, the input prices will come down causing the supply curve to shift to the right (increase supply) thereby lowering the equilibrium price of healthcare services (See Exhibit 5).
The opponents of HSA accounts feel that the market will continue to fail in allocating resources efficiently for health care because of the high expense of life-extending health treatment and the search for new treatments. They feel that HSAs will only cover the minor medical expenses, leaving the HDHP to cover the major medical issues that are typically the highest costs. Their opinion is that HSAs will not change the insurance companies influence on high-cost treatments, which may cause more strict regulations by the government.
The long-term effects of HSAs in the United States have yet to be seen, barring the data from similar plans around the country and world. However, it is clear that the government’s creation of HSA accounts has provided a more-even playing field for many Americans who would not otherwise be able to afford insurance. Small business owners can set up HSA accounts for themselves and their employees, preventing their potential bankruptcy due to major medical expenses and providing their employees a means to better control their health care costs. Furthermore, small business health care companies can provide more competitive pricing, as they do not have to spend time filling out and submitting insurance forms. Although HSA accounts may not be for everyone, they have certainly created a new market that has the potential to provide more stability to the current health care market and society as a whole.
Conclusion
Our analysis of the HSA legislation vis-à-vis economic principles suggests that the legislation is compatible with economic principles in a way that will give it the intended effectiveness and the desired outcomes, i.e. lower healthcare costs and more control to the individual on how their healthcare dollars are spent. Furthermore, evidence available from medical savings accounts in the USA (predecessor of HSAs in USA) and South Africa, although limited, supports our analysis. Our understanding of economic principles provided a sound framework on which to analyze this legislation. We believe that the Administration’s meddling into healthcare contradicts the free market ideals upon which the HDHP and HSA legislation was created.
Exhibit 1: Comparison of Specific Health Accounts
Exhibit 2: Qualified Medical Expenses under HSA Legislation
Exhibit 3: Comparison of PPO versus HDHP for insured base of 84 heads
Exhibit 4: Calculation of Tax Savings (Using 2004 Federal Income Tax Rates)
Exhibit 5: Shift in the Supply Curve due to Reduced Input Prices (Administrative Costs)
Exhibit 2: Qualified Medical Expenses under HSA Legislation
Exhibit 3: Comparison of PPO versus HDHP for insured base of 84 heads
Exhibit 4: Calculation of Tax Savings (Using 2004 Federal Income Tax Rates)
Exhibit 5: Shift in the Supply Curve due to Reduced Input Prices (Administrative Costs)
