Economic Theory

The case for a prefunded healthcare system

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.

One of the main drivers is population ageing. Healthcare costs rise exponentially in old age. They 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. There are currently about 28 people of retirement age for every 100 people of working age. This ratio is forecast to rise to 47 for every 100 over the next five decades. Within the pensioner population, the share of octogenarians and nonagenarians is set to increase as well. There are currently just 4 people over the age of 84 for every 100 people of working age. This ratio is forecast to rise 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 only root-and-branch solution that would defuse the demographic time bomb is to move to a prefunded system. This is the solution I explore in my new IEA Discussion Paper A piggy bank for healthcare. Why the health system needs old-age reserve funds, released today.

In a nutshell, such a system would build up old-age reserves, comparable to pension funds, for people of working age, and then draw upon them when people retire. 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.

The paper explains that 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, the impact of political decisions that will lead to future spending increases would already be felt today, because we would have to start building up the corresponding reserves today. Thus, it would no longer be possible for politicians to make costly promises today, and leave the bill for future governments (or rather, future taxpayers) to pay. Thus, a prefunded system would not require farsighted politicians: even a short-sighted government would be forced to act as if they were far-sighted.

The case for prefunding is well explored in the economic literature, and the paper discusses a number of 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.

Real-world examples, however, are rare. The paper discusses the two closest things: 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). These MSAs are not old-age funds: unlike a pension fund, people use them throughout their lives. But the account balance would typically grow with age, and reach a peak around retirement, before people start drawing them down. Thus, they do mirror pension funds.

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. This is more than eight times their annual expenditure, which means that even if all revenue came to a complete standstill, the prefunded part of the system could still keep going for years. 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: my 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.


Download the Discussion Paper ‘A piggy bank for healthcare’ here.

Head of Political Economy

Dr Kristian Niemietz is the IEA's Head of Political Economy. Kristian 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). He also studied Political Economy at King's College London, graduating in 2013 with a PhD. Kristian previously worked as a Research Fellow at the Berlin-based Institute for Free Enterprise (IUF), and taught Economics at King's College London. He is the author of the books "Socialism: The Failed Idea That Never Dies" (2019), "Universal Healthcare Without The NHS" (2016), "Redefining The Poverty Debate" (2012) and "A New Understanding of Poverty" (2011).

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