Why the health system needs old-age reserve funds

Summary:

  • Healthcare spending as a proportion of GDP has almost doubled since 1990, from just over 5 per cent to almost 10 per cent now. With differences in timing and magnitude, virtually all developed countries have experienced a similar long-term trend

  • Healthcare costs rise exponentially in old age. Healthcare costs per capita are relatively stable during, roughly, the first five decades of life. But they then double over the next two decades, and double again over the following decade. The healthcare costs of people over the age of 85 are more than five times as high as the healthcare costs of young and middle-aged people. This means that most healthcare spending represents a transfer from the working-age generation to the retired generation.

  • The combination of rising life expectancy and low birth rates therefore represents a demographic pincer movement for the health system. The ratio of people of retirement age to people of working age currently stands at 28 to 100. This is forecast to rise to 47 to 100 by 2064. In the same period, the share of people aged 85 and over is forecast to rise from 4 for every 100 people of working age to 13 per 100.

  • The Office for Budget Responsibility (OBR) predicts only modest increases in NHS spending as a proportion of GDP, but this forecast is predicated on the heroic assumption that the NHS is going to double its long-term productivity growth rate. The OBR does not say where this sudden productivity revolution is supposed to come from, but admits that its estimate is highly sensitive to assumptions about productivity, and that the increase in costs would be vastly greater if productivity growth fails to accelerate.

  • The basic problem is that the NHS (like most healthcare systems) is financed on a pay-as-you-go basis: all current expenditure is paid out of current revenue; the system never builds up any reserves. The alternative would be a prefunded system that builds up old-age reserves (comparable to pension funds) for people of working age, and then draws upon them when people retire. In such a system, population ageing would be much less of a problem, because as the number of elderly people grows, the reserves accumulated in the old-age funds would grow alongside.

  • Prefunding has a number of theoretical advantages. Old-age funds would earn a rate of return. The rate of savings and investment would increase, which would, in turn, increase the economy’s capital stock, its productivity and, indirectly, wage levels. A prefunded system would also have a more diversified funding base, which would decrease the risk of sudden, erratic changes in healthcare spending. Perhaps most importantly, it would improve the quality of decision-making. In a prefunded system, decisions about future spending would be felt today, because we would have to start building up the reserves today. This means that even a short-sighted government could be forced to act as if they were far-sighted.

  • The case for prefunding is well explored in the economic literature, and there are a number of interesting proposals for moving towards a fully or partially prefunded health system. These proposals have been developed in the context of very different healthcare systems (namely the Canadian, the American and the German system), which shows that virtually any type of system could be run on a prefunded basis.

  • While there is no shortage of theoretical literature, real-world examples of prefunded healthcare are rare. The two closest things are the Singaporean ‘Medisave’ system and the German PKV (sub-) system. The former is a system of compulsory savings for medical expenses, based on individual Medical Savings Accounts (MSAs). As Singaporeans put money into their MSAs throughout their working life, their account balance grows with age, until they start drawing them down in old age. They can bequeath the remainder to their heirs.

  • Germany, meanwhile, has two parallel health insurance systems, one of which is prefunded. Insurance companies in this branch of the system build up old-age reserves on behalf of their clients while they are of working age, and draw upon those reserves later, in order to smoothen insurance premiums over people’s lifecycle. Taken together, insurers in this sub-system – which covers about 8 million people – have accumulated old-age reserves worth nearly €190 billion, or more than €21,000 per client. Even if all revenue came to a complete standstill today, the PKV system could still keep going for another eight years by drawing upon those reserves. The PAYGO-financed branch of the system, in contrast, would immediately collapse.

  • The NHS could begin to build up a similar old-age reserve fund. This would require a one-off increase in taxes, or spending cuts in the non-healthcare budget. But it would prevent steeper tax increases (or spending cuts) in the future. While the basic idea of prefunding is simple, a lot of details would need to be worked out first: this paper cannot do more than touch the surface. But at the moment, the idea of prefunding healthcare expenditure is not even part of our healthcare debate. It should be.


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Head of Health and Welfare

Dr Kristian Niemietz joined the IEA in 2008 as Poverty Research Fellow, becoming its Senior Research Fellow in 2013 and Head of Health and Welfare in 2015. Kristian is also a Fellow of the Age Endeavour Fellowship. He studied Economics at the Humboldt Universität zu Berlin and the Universidad de Salamanca, graduating in 2007 as Diplom-Volkswirt (≈MSc in Economics). During his studies, he interned at the Central Bank of Bolivia (2004), the National Statistics Office of Paraguay (2005), and at the IEA (2006). In 2013, he completed a PhD in Political Economy at King’s College London. Kristian previously worked as a Research Fellow at the Berlin-based Institute for Free Enterprise (IUF), and at King's College London, where he taught Economics throughout his postgraduate studies. He is a regular contributor to various journals in the UK, Germany and Switzerland.