Social Insurance and Economic Security [7 ed.] 9781315700731, 9780765627483

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Social Insurance and Economic Security

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Social Insurance and Economic Security Seventh Edition

George E. Rejda ROUTLEDGE

Routledge Taylor & Francis Group

LONDON AND NEW YORK

First published 2012 by M.E. Sharpe Published 2015 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN 711 Third Avenue, New York, NY 10017, USA Routledge is an imprint of the Taylor & Francis Group, an informa business Copyright © 2012 Taylor & Francis. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Notices No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use of operation of any methods, products, instructions or ideas contained in the material herein. Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein. In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility. Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Library of Congress Cataloging-in-Publication Data Rejda, George E., 1931Social insurance and economic security / George E. Rejda—7th ed. p. cm. Includes bibliographical references and index. ISBN 978-0-7656-2748-3 (cloth : alk. paper)—ISBN 978-0-7656-2749-0 (pbk. : alk. paper) 1. Social security—United States. 2. Economic security—United States. I. Title. HD7125.R37 2011 368.4’300973—dc22

ISBN 13: 9780765627490 (pbk) ISBN 13: 9780765627483 (hbk)

2011021489

Contents

Preface

ix

1

Economic Security and Insecurity Nature of Economic Security Nature of Economic Insecurity Causes of Economic Insecurity Concept of Social Security Meaning of Social Insurance Reducing Economic Insecurity

3 3 5 6 14 15 17

2

Basic Principles of Social Insurance Basic Principles and Characteristics of the OASDI Program Is the OASDI Program Insurance? Welfare Component Social Insurance Compared with Private Insurance Social Insurance Compared With Public Assistance Economic Objectives of Social Insurance Programs

24 24 30 33 33 36 37

3

Problem of Premature Death Definition of Premature Death Economic Impact of Premature Death on the Family Reducing Economic Insecurity from Premature Death

43 43 46 52

4

Problem of Old Age Nature of the Old-Age Problem Employment Problems of Older Workers Reducing Economic Insecurity During Retirement

64 65 76 77

5

Old-Age, Survivors, and Disability Insurance Development of the Social Security Act Covered Occupations Determination of Insured Status

97 97 100 102 v

vi  Contents



Benefit Amounts Types of Benefits Loss or Reduction of Benefits Taxation of Social Security Benefits Financing the Social Security Program Administration

104 107 115 118 118 119

6

Problems and Issues in the Social Security Program Higher Full Retirement Age Adequacy of Benefits Disability Income Problems and Issues Public Confidence in the Social Security Program Getting Your Money’s Worth Reducing Social Security Payroll Taxes to Stimulate the Economy

124 124 126 132 136 137 142

7

Financing the Social Security Program Methods of Financing No Full Funding Actuarially Sound Program Social Security Trust Funds Financial Condition of Social Security and Medicare Solutions to the Long-Range Deficit

151 151 152 152 153 155 158

8

Problem of Poor Health and Health-Care Reform Health-Care Problems in the United States Rising Health-Care Expenditures Large Number of Uninsured in the Population Uneven Quality of Medical Care Waste and Inefficiency Defects in Financing Health Care Abusive Insurer Practices Earlier Health-Care Reform Efforts Basic Provisions of the Affordable Care Act

167 168 168 172 174 174 175 175 179 179

9

Health-Care Reform and Private Health Insurance Impact of Health-Care Reform on Individual and Group Coverage Individual Health Insurance Coverages Disability Insurance Long-Term Care Insurance Group Health Insurance Coverage Traditional Indemnity Plans Managed Care Plans Consumer-Directed Health Plans Continuation of Health Insurance for Terminated Employees Recent Developments in Group Medical Expense Plans Group Disability Income Insurance

195 196 197 202 204 206 207 208 212 212 213 214

Contents 

vii

10

Health-Care Reform and the Medicare Program Overview of Medicare The Original Medicare Plan Medicare Advantage Plans Other Medicare Health Plans Medicare Prescription Drug Coverage Extra Help Program Medigap Insurance Care Outside the United States Medicare Savings Programs Medicare Problems and Issues Impact of the Affordable Care Act on Medicare

222 223 223 228 230 230 232 232 232 233 234 239

11

Problem of Occupational Injury and Disease Occupational Injury Occupational Disease Areas of Concern Costs of Occupational Injuries and Disease Reducing Occupational Injuries and Disease Occupational Safety and Health Act of 1970

245 246 247 249 251 253 256

12

Workers’ Compensation Development of Workers’ Compensation Objectives of Workers’ Compensation Theories of Workers’ Compensation State Workers’ Compensation Laws Coordination with Other Programs Second-Injury Funds Financing of Workers’ Compensation Administration of Workers’ Compensation Problems and Issues in Workers’ Compensation Improving Workers’ Compensation Laws

264 264 266 269 270 275 276 276 277 277 280

13

Problem of Unemployment Types of Unemployment Measurement of Unemployment Unemployment in the United States Underemployment of Human Resources Who Are the Unemployed? Current Approaches for Reducing Unemployment

288 289 292 294 297 298 301

14

Unemployment Compensation Development of Unemployment Compensation Objectives of Unemployment Compensation State Unemployment Compensation Provisions Extended Unemployment Benefits

313 314 316 318 325

viii  Contents



Temporary Emergency Unemployment Compensation Unemployment Compensation for Special Groups Financing Unemployment Compensation Unemployment Trust Fund Administration Taxation of Benefits Temporary Disability Insurance

326 327 328 331 332 332 332

15

Problems and Issues in Unemployment Compensation Decline in the Proportion of Unemployed Workers Receiving Benefits Adequacy of Weekly Benefit Amount High Disqualification Rates for Certain Claims Exhaustion of Benefits Inadequate Financing Size of the Taxable Wage Base Misclassification of Employees Disincentive Effects of Unemployment Compensation Modernizing State Unemployment Compensation Programs

340 341 343 345 346 347 348 349 349 352

16

Public Assistance Programs Basic Characteristics of Public Assistance Reasons for Public Assistance Public Assistance Compared with Social Insurance Types of Public Assistance Programs Supplement Security Income (SSI) Temporary Assistance for Needy Families Medicaid Medicaid Problems and Issues Impact of Health-Care Reform on Medicaid General Assistance

361 362 362 363 364 364 366 370 374 374 376

17

Economic Security Programs for Special Groups Veterans Railroad Workers Financial Status of the Railroad Retirement System Railroad Unemployment Insurance Act Federal Civilian Employees Federal Employees Retirement System State and Local Government Retirement Plans Financing Problems and Issues

382 382 388 392 392 395 397 400 401

Index About the Author

409 425

Preface

This text deals with the nature and causes of economic insecurity in the United States. Primary emphasis is on social insurance programs aimed at reducing economic insecurity. Since the last edition of this text appeared, several unprecedented events have occurred that clearly show the destructive presence of economic insecurity in the economy. In the severe 2007–2009 downswing, the economy experienced a massive financial meltdown and a brutal stock market crash that substantially reduced the life savings of most workers; fear and panic were widespread; the economy and monetary system came terrifyingly close to a catastrophic collapse; more than 15 million workers lost their jobs; and numerous commercial banks and financial institutions failed, producing a credit crunch and a freezing of credit markets. The housing market collapsed, foreclosures increased, and millions of homeowners lost their homes or owed more than the value of their homes. The Federal Reserve intervened and implemented several unusual policies to rescue the nation from the second-worst economic downswing in its history, next only to the Great Depression of the 1930s. In addition, Congress enacted a controversial and costly federal program to stimulate the economy. Congress also engaged in a bitter and contentious debate over health care in the United States. The heated and partisan debate resulted in enactment of the historical Affordable Care Act in 2010 to reform health care and a broken health-care delivery system. Flash forward to the present. The economy is slowly recovering, and the stock market has recovered a significant part of its losses. The unemployment rate, however, remains stubbornly high, and millions of unemployed workers have exhausted their unemployment benefits. Congress is engaged in a bitter and divisive debate on how to reduce the federal deficit and create new jobs, and the Affordable Care Act is under heavy attack by opponents who want the new law repealed. To say that we live in a fragile economy with widespread economic insecurity is an enormous understatement. The seventh edition of Social Insurance and Economic Security discusses the above problems and other causes of economic insecurity as well. Like earlier editions, the seventh edition of this text is designed for a one-semester course in social insurance and income maintenance programs at either the undergraduate or graduate level. ix

x  Social Insurance

and

Economic Security

The text can also be profitably used in labor economics courses and in courses that emphasize public assistance and welfare programs. The central thrust of the seventh edition is an up-to-date analysis of Social Security and Medicare, workers’ compensation, unemployment compensation, public assistance, and the new Affordable Care Act that deals with health-care reform. The basic principles, characteristics, and public-policy issues associated with major social insurance programs and public assistance programs are discussed in considerable depth. Each major cause of economic insecurity is examined, and the appropriate social insurance program for dealing with the problem is analyzed in some detail. The new Affordable Care Act is emphasized heavily in four chapters.

Key Content Changes in the Seventh Edition The seventh edition required a considerable amount of rewriting, especially in the areas of Social Security, unemployment insurance, and health care. Key content changes include the following: • Completely Updated. The seventh edition is thoroughly updated to reflect recent changes in Social Security, workers’ compensation, and unemployment insurance. The new Affordable Care Act dealing with health-care reform is discussed in depth. The number of chapters has been reduced from 18 to 17. • Social Security Reform. Chapter 6 discusses the various proposals for reforming Social Security. These proposals include raising the full retirement age, changing the benefit formula, reducing the cost-of-living adjustment, increasing benefits for certain vulnerable groups, and other proposals as well. • Economic Insecurity from Poor Health. Chapter 8 includes an expanded discussion of the economic problem of poor health; major reasons for the historical increase in health-care expenditures; problems of the uninsured; fraud and waste; and abusive insurer practices, which led to enactment of the Affordable Care Act. • Affordable Care Act. When fully implemented, the Affordable Care Act will have a profound impact on the present health-care delivery system. Chapters 8, 9, 10, and 16 discuss the basic provisions of the Affordable Care Act and its impact on individual and group health insurance coverage, as well as the Medicare and Medicaid programs. • Getting Your Money’s Worth. The section addressing the complex issue of whether workers receive their money’s worth under the Old-Age, Survivors, and Disability Insurance (OASDI) program has been updated and expanded based on a model developed by Social Security actuaries. This model reflects the value of major Social Security benefits to individuals and families, which include retirement, survivor, and disability benefits. Earlier models tended to focus primarily on retirement benefits. • Financial Problems of Social Security and Medicare. Chapter 7 discusses in considerable detail the short-range and long-range financial problems of Social

Preface  xi

Security and Medicare. The various proposals for reducing the long-range deficit are discussed in some depth. • Updated Discussion of Unemployment Compensation. Chapters 13–15 have been updated to reflect the problem of unemployment during the recent 2007–2009 recession and the present defects of unemployment compensation in reducing economic insecurity. The chapters also discuss the various proposals for improving the system.

Acknowledgments A successful textbook is seldom written alone. I owe a heavy intellectual debt to the following individuals and organizations, who reviewed all or selected parts of the manuscript, offered comments, answered questions, or provided technical support: • Ann Costello, University of Hartford • William Kostner, Risk Manager, City of Lincoln, Nebraska • Bill Davenport, Nebraska Department of Health and Human Services • Joseph D. Haley, St. Cloud State University • Ken J. Dolezal, Nebraska Department of Labor • Michael J. McNamara, Washington State University • Paul Royster, University of Nebraska—Lincoln • Alice Wade, Office of Chief Actuary, Social Security Administration • National Academy of Social Insurance The views expressed in the text are solely those of the author and do not necessarily reflect the viewpoints or position of the reviewers whose assistance I am gratefully acknowledging. Finally, the fundamental objective underlying the seventh edition remains the same as in earlier editions—I have attempted to write a textbook from which students can learn and professors can teach.     George E. Rejda, PhD, CLU     University of Nebraska–Lincoln

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Social Insurance and Economic Security

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1 Economic Security and Insecurity

Student Learning Objectives After studying this chapter, you should be able to: • Explain the meaning of economic security. • Explain the meaning of economic insecurity. • Identify the major causes of economic insecurity. • Describe the basic characteristics of social insurance programs. • Identify major private and public programs that reduce economic insecurity. People have always sought protection against those forces that threaten their security. Because life is full of uncertainty and pervaded by complex threatening forces, the concept of security can be analyzed from several disciplines, including economics, political science, sociology, philosophy, and national defense. A complete analysis of security, however, is a burdensome, if not impossible, task. Thus, the concept of security must be narrowed. In this text, economic security will be emphasized, with primary emphasis on social insurance programs as a major technique for combating insecurity. In this chapter, we examine the nature and causes of economic insecurity, the meaning of social security, and the generic characteristics of social insurance. We conclude the chapter with a discussion of the major techniques for reducing economic insecurity.

Nature of Economic Security Total welfare for an individual or family is the sum of a large number of different parts. Although total welfare cannot be broken up in the sense that one can attribute parts of the whole to the various elements from which that welfare is obtained, it is clear that a large part of our total welfare is derived from things obtainable with 3

4  Economic Security

and Insecurity

money.1 Economic security, which is part of our total welfare, can be defined as a state of mind or sense of well-being by which an individual is relatively certain that he or she can satisfy basic needs and wants, both present and future. The phrase “basic needs and wants” refers to a person’s desire for food, clothing, housing, medical care, and other necessities. When a person is relatively certain that both present and future needs and wants can be reasonably satisfied, then he or she may experience a sense of well-being. This sense of well-being, which results from the satisfaction of human needs and wants, depends on the use of economic goods and services. An individual must have access to sufficient goods and services to attain economic security. It is obvious, therefore, that in a highly industrialized economy, economic security is closely related to the maintenance of income. The more income a person has—whether from money wages, savings, public or private transfer payments, or the ownership of property—the greater the level of economic security that is possible. In analyzing the preceding concept of economic security, four points must be kept in mind. First, as stated earlier, money income is a key factor in attaining economic security. The income, however, must be continuous. A person must have some reasonable expectation that his or her income will continue so that both present and future needs and wants will be reasonably satisfied. If money income is lost or significantly reduced, economic security is threatened. Second, although money income is a critical factor in attaining economic security, real income must also be considered. Real income refers to the amount of goods and services that can be purchased with money income. If real income increases, an improvement in economic security is possible. For example, if money income increases 10 percent over time, and consumer prices increase only 5 percent, real income is increased, and greater economic security is possible. However, in recent years, the wages of millions of American workers did not keep pace with inflation. As a result, these workers experienced an erosion of economic security. Third, for most people, economic security requires the receipt of money income that is above the poverty or subsistence level of living. Poverty can be defined as an insufficiency of material goods and services by which the basic needs of individuals or families exceed their means to satisfy them. Poverty can be crudely measured by various poverty thresholds established by the U.S. Census Bureau. The poverty thresholds do not vary geographically, but they are updated for inflation based on the Consumer Price Index (CPI-I). The official poverty definition is based on money income before taxes and does not include capital gains or noncash benefits such as food stamps and public housing. In 2010, the U.S. Census Bureau estimated that 46.2 million persons were living in poverty, or a poverty rate of 15.1 percent.2 Thus, millions of Americans currently are not economically secure because their incomes are below poverty levels. Finally, economic security is relative to the standard of living enjoyed by others. As the standard of living enjoyed by others changes over time, the concept of economic security will also change. The nation’s rate of economic growth, social mores, educational level, cultural background, and stage of economic development has an important impact on the concept of economic security. As these factors change over

Nature

of

Economic Insecurity  5

time, the expectations of consumers and families will also change, which results in a changing concept of economic security.

Nature of Economic Insecurity Economic insecurity is the opposite of economic security; that is, the sense of wellbeing or state of mind that results from being relatively able to satisfy both present and future needs and wants is lacking. Instead, there is considerable worry, fear, anxiety, frustration, and psychological discomfort. The need for money to pay current bills is a constant problem. Individuals can experience economic insecurity if their incomes are lost or substantially reduced, if they must assume or pay excessive or additional expenses, or if they earn an insufficient income relative to expenses. Economic insecurity may also be present if there is uncertainty concerning the continuation of future income. Thus, economic insecurity consists of one or more of the following: • Loss of income • Additional expenses • Insufficient income • Uncertainty of income

Loss of Income A worker may lose his or her money income or may experience erosion in real income over time because money wages fail to keep up with inflation. Regardless of whether the income loss is absolute or relative, economic insecurity is present when the worker’s income is lost. In such a case, unless the worker has sufficient financial assets, past savings, or other sources of replacement income, basic needs and wants cannot be satisfied. Moreover, the continuous consumption of goods and services above the poverty line may be difficult because of the income loss.

Additional Expenses Economic insecurity can also result from additional expenses that exceed the worker’s ability to pay, such as catastrophic medical bills. For example, assume that a male worker with no health insurance and limited savings has prostate cancer and incurs medical bills of $200,000. In addition to the loss of earned income, he may find that payment of medical bills is financially burdensome. Likewise, assume that an uninsured motorist fails to stop at a stop sign and seriously injures a pedestrian, and that a court of law awards damages of $300,000 to the injured pedestrian. If the uninsured motorist is unable to satisfy the judgment, a lien may be placed on his or her income and financial assets. In addition, legal defense costs may be enormous if an attorney is retained. Unless the negligent motorist has sufficient auto liability insurance, adequate savings, or other sources of income from which to draw, economic insecurity is present because of the additional expenses.

6  Economic Security

and Insecurity

Insufficient Income Economic insecurity is also present if a person is employed but earns an insufficient income; that is, total income during the year is less than the amount needed to satisfy basic necessities. For example, in 2010, assume that a single mother with two children worked 40 hours weekly throughout the entire year at an hourly wage of $8. Her annual income is $16,640, which is below the federal poverty level of 18,310.3 The family is exposed to economic insecurity because of insufficient income. As stated earlier, millions of Americans experience economic insecurity because of poverty. The viewpoint that some people are poor because they refuse to work or cannot find employment, or because they have some mental or physical defect that makes employment difficult, is not entirely correct. Many poor workers are steadily employed and work regularly throughout the entire year, but their incomes are insufficient to satisfy their basic needs and wants.

Uncertainty of Income Economic insecurity may also be present if employed workers are uncertain of the future continuation of their income. In the highly industrialized American economy, a chronic fear of unemployment may create considerable fear and anxiety for workers because it threatens the feeling of economic security and well-being. For example, during a severe business recession, a global corporation may issue a press release stating that 10,000 employees will be laid off. In such a case, employees of the corporation may experience considerable fear, anxiety, and psychological discomfort because of the uncertainty of losing their jobs and earned income. If workers believe that their jobs will be lost, or that hours of work will be significantly reduced, economic insecurity is present because of the uncertainty of future income.

Causes of Economic Insecurity The major causes of economic insecurity today in the United States include the ­following: • Premature death of the family head • Old age • Poor health • Unemployment • Substandard wage • Inflation • Natural disasters • Children born outside of marriage • Personal factors

Causes

of

Economic Insecurity  7

Premature Death of the Family Head Premature death can be defined as death of a family head with unfulfilled financial obligations. These obligations include dependents to support, children to educate, a mortgage to be paid off, credit card debts, and installment loans. Premature death of the family head can cause economic insecurity because of the loss of earned income. If the surviving family members receive an insufficient amount of replacement income from other sources to meet their basic needs, or have limited savings and financial assets to replace the lost income, they will experience economic insecurity. The family may also incur substantial additional expenses because of funeral costs, uninsured medical bills, estate and death taxes, and probate costs. Additional funds may be needed to pay off credit card and installment debts, the remaining balance on the mortgage, and funding for the children’s college education. Finally, certain noneconomic costs are also incurred, including emotional grief and pain of the surviving dependents, loss of a role model, and the loss of counseling and guidance for the children. Premature death, however, can cause economic insecurity only if the deceased individual has dependents to support or dies with unsatisfied financial obligations. Thus, the death of a child, age 7, is not regarded as being premature in the economic sense.

Old Age Old age is another important cause of economic insecurity in the United States. In 2010, 40.3 million persons in the United States, or 13 percent of the resident population, were age 65 or older.4 Although the financial position of the elderly has improved over time, many older persons are economically insecure. Old age can cause economic insecurity because of the loss of earned income. When older workers retire, they lose their earned income. Unless they have accumulated sufficient financial assets on which to draw, or have access to adequate replacement income from other sources, such as Social Security, 401(k) plans, or individual retirement accounts (IRAs), they will be exposed to economic insecurity. Many retired workers also experience economic insecurity because of insufficient income. Most retirees are not poor. However, in 2010, 9 percent of people age 65 or over were living in poverty.5 For these persons, considerable economic insecurity was present because of insufficient income. In addition, many retired people experience economic insecurity because of poor health and sizable medical bills. Although Medicare covers chronic illness and disease of people 65 and over, it provides only limited coverage for skilled nursing care, and custodial care is excluded altogether. Many elderly require long-term custodial care in nursing homes, and the financial burden is staggering. In many communities, annual long-term costs can easily exceed $100,000, $150,000, or some higher amount. Because of limited incomes, the majority of retired workers do not have long-term care insurance because of cost. Depending on location and age, long-term care

8  Economic Security

and Insecurity

p­ remiums for people age 65 or older can be $3,000, $4,000, or some higher amount each year. Many retired people cannot afford these high premiums. As a result, many elderly who need nursing-home care apply for coverage under the Medicaid program, which should not be confused with Medicare. Medicaid is a state and federal welfare program with a stringent means test for eligibility. Medicaid is discussed in greater detail in Chapter 16. In addition, some retired persons experience economic insecurity because of early retirement and inadequate income, erosion of real income because of inflation, high property taxes, exploitation, and physical abuse. These problems are discussed in greater detail in Chapter 4 when the economic problem of old age is analyzed.

Poor Health Poor health is a major cause of economic insecurity. The problem of poor health includes payment of catastrophic medical bills and the loss of earned income. Medical care is expensive. Major surgery or a serious illness or injury can easily cost $50,000, $100,000, or some higher amount. Although most Americans have some type of health insurance coverage, a large number of people are uninsured for some time during the year. According to the 2011 Current Population Survey, 49.9 million people, or 16.3 percent of the population, had no health insurance coverage in 2010.6 As a result, this group was exposed to serious economic insecurity. The issue of medical care for the uninsured is a serious national problem that is discussed in greater detail in Chapter 8. In addition, many sick or disabled people experience economic insecurity even if they have health insurance. Because of catastrophic medical bills, lifetime limits on benefits in earlier policies, various policy exclusions, denial of claims by health insurers, and abusive claims practices by insurers, many sick or disabled persons are unable to pay their medical bill and are forced to declare bankruptcy. A national study of bankruptcies by Harvard researchers concluded that medical problems contributed to 62 percent of all bankruptcies in 2007. Three-quarters of the filers had health insurance. Most filers were well educated, owned homes, and had middle-class occupations.7 A severe illness or injury also results in the loss of earned income. The probability of becoming disabled before retirement is much higher than is commonly believed, especially at the younger ages. According to the Social Security Administration, studies show that a 20-year-old worker has a 3 in 10 chance of becoming disabled before reaching retirement age.8 In cases of long-term disability, there is a substantial loss of earned income, medical expenses still continue, savings often are depleted, employee benefits may be lost or reduced, and someone must care for a permanently disabled person. Unless there is adequate replacement income from other sources during the period of disability, considerable economic insecurity is present. Economic insecurity from poor health should be reduced in the future as the provisions of new health-care reform legislation become effective. In early 2010, Congress enacted controversial health-care reform legislation to reduce the defects

Causes

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Economic Insecurity  9

in the present health-care delivery system. The Patient Protection and Affordable Care Act, amended as the Health Care and Education Reconciliation Act of 2010, extends health-care coverage to 32 million uninsured Americans, provides substantial subsidies to uninsured individuals and small business firms to make health insurance more affordable, contains provisions to lower health-care costs in the long run, and prohibits insurers from engaging in certain practices. The legislation also prohibits (1) medical underwriting based on health status, (2) exclusions for pre-existing conditions, (3) maximum limits on lifetime benefits and unreasonable annual limits on benefits, and (4) rescission of health insurance policies when insured people get sick. Although most provisions do not become effective until 2014, some provisions became effective immediately. Health-care reform legislation is discussed in greater detail in Chapter 8.

Unemployment Unemployment is a leading cause of economic insecurity. In 2008 and 2009, the United States experienced the second worst business downswing in its history, next only to the Great Depression of the 1930s. During this period, the unemployment rate surged to 10.1 percent in October 2009, and 15.6 million workers were unemployed. The severe recession was caused by numerous factors. A housing bubble broke, and foreclosures increased sharply; the subprime real estate market collapsed because many homebuyers with marginal credit records purchased homes they could not afford, or obtained adjustable-rate mortgages they did not understand; and financial institutions generally had lax lending standards and often made predatory and undocumented mortgage loans. Many homeowners relied heavily on home equity loans, used credit cards excessively, and defaulted on their mortgage payments. Banks and insurers sold complex credit default swaps and other derivatives in unregulated markets that resulted in billions of dollars of losses. Commercial banks generally were overleveraged and undercapitalized; numerous banks failed or were forced to merge with other banks; and credit became more difficult to obtain. Finally, lax regulatory oversight at both the state and federal level also contributed to the financial meltdown. Regardless of the cause, extended unemployment can bring about economic insecurity in at least three ways. First, workers lose their earned income and employee benefits. Unemployed workers typically lose their group health insurance unless they exercise their right to remain in their employer’s plan under the Consolidated Omnibus Budget Reconciliation Act (COBRA). However, unemployed workers generally must pay 102 percent of the group premium, which often makes the cost prohibitive.9 Second, during economic downswings, many firms reduce the number of hours of work or the number of work shifts. As a result, some workers can work only part-time with a substantial reduction in earned income. Also, millions of unemployed workers often become discouraged and drop out of the labor force because they believe jobs are not available. As such, economic insecurity is aggravated during spells of long-term unemployment. Finally, if the duration of unemployment extends over a long period, past savings and unemployment compensation benefits may be exhausted. If older workers are

10  Economic Security

and Insecurity

nearing retirement and become unemployed for an extended period, the reduction or exhaustion of their savings may result in a lower standard of living during retirement.

Substandard Wage A substandard wage can also cause economic insecurity. A substandard wage is any wage that is below some specified minimum necessary for workers to support themselves and their families. The wage rate paid is so low that family heads cannot adequately support themselves and their families if they are paid at that rate for any extended period. The federal minimum wage of $7.25 per hour is an example of a substandard wage. If a family head with several dependents is paid at that rate for any extended period, the worker and his or her family will be living in poverty.

Inflation As stated earlier, if consumer prices rise at a faster rate than money income, real income declines, and economic security is threatened. The United States at times has been plagued by severe inflation. A rapid increase in prices tends to hurt those workers whose wages lag behind the increase in prices. In particular, family heads who are paid only the federal minimum wage are severely hurt by rapid inflation. The cost of food, housing, gasoline, work expenses, medical care, utilities, and other necessities will often increase substantially. The working poor are then confronted with the unpleasant dilemma of spending more of their limited incomes on these necessities in order to survive. Considerable economic insecurity is the result.

Natural Disasters Floods, hurricanes, earthquakes, tornadoes, forest and grass fires, and other natural disasters can result in billions of dollars in property damage, as well as numerous deaths. The increase in economic insecurity is substantial. For example, Hurricane Katrina, in August 2005, was the largest natural disaster in the history of the United States. Total property damage was estimated at $81 billion, and more than 1,800 people died.10 Likewise, in January 2010, one of the deadliest and most devastating earthquakes in history struck Haiti. The Haitian government reported that an estimated 316,000 people died, 300,000 were injured, and 1,000,000 became homeless.11 Natural disasters cause economic insecurity because of the loss of human life and resulting loss of income to the stricken families; property damage losses are catastrophic; families are forced to relocate and often become homeless; property damage from floods and earthquakes is either uninsured or underinsured, causing substantial additional expenses; and the mental pain, worry, fear, and psychological discomfort experienced by affected individuals and families increase to frighteningly high levels.

Causes

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Economic Insecurity  11

Children Born Outside of Marriage Children born outside of marriage are another major cause of economic insecurity. The proportion of births to unmarried mothers has risen sharply over the past few decades. According to the National Center for Health Statistics, unmarried women accounted for about 40 percent of the births in the United States in 2007.12 Between 1980 and 2007, the proportion of births to unmarried women has more than doubled. The substantial increase in unmarried births may be due, at least partly, to cohabitating couples who are not married. These relationships are less stable than marriage. Many unmarried mothers with minor children experience economic insecurity because of several factors. If a cohabitating couple with children separates, the mother typically receives custody of the children. The big problem here is insufficient income. Many unmarried mothers have limited work skills, which keep them in relatively low-paying jobs. Also, as stated earlier, the financial burden of raising and educating the children falls heavily on unmarried mothers; these costs are substantial, and childsupport payments from the fathers generally do not fully cover child-rearing costs. Moreover, many fathers default on their child-support payments, or the payments are late or sporadic. Many judges sentence fathers to jail for extended periods because they are behind in their child-support payments, which only aggravates the problem of insufficient income. Also, a state may revoke the driver’s license of someone who is delinquent in child-support payments, which makes it more difficult for the person to work, again aggravating the problem of insufficient income. In addition, unmarried teenage mothers generally lack marketable skills that would enable them to obtain high-paying jobs and often do not receive child-support payments from the fathers. Many unmarried teenage mothers apply for aid from the Temporary Assistance for Needy Families (TANF) program, a welfare program that has a stringent means test and provides only a subsistence level of income. As a result, unmarried teenage mothers often seek additional financial help from parents, relatives, and other sources. Finally, the burden and stress of caring for a baby makes it difficult for some unmarried teenagers to complete their high school education. As a result, they drop out of school without graduating, which almost guarantees a life of poverty. The poverty rate for female householders with children under age 18 and no husband present was 37.2 percent in 2008.13 Unmarried teenage mothers are an important part of this group.

Personal Factors In some cases, individuals are primarily responsible for their own economic insecurity. Some people are poorly motivated and have little desire to improve themselves. Others have personal problems that interfere with their relationships with other people. Still others are spendthrifts, fail to save for contingencies, and are often late paying their bills and debts or ignore them altogether. In addition, many people have addictive habits, such as alcohol, substance abuse, or gambling, that result in economic insecurity. Finally, some people are greedy, imprudent, and make unwise investments, which often result in substantial financial losses and financial insecurity.

12  Economic Security

and Insecurity

Personal factors are especially important in certain major social problems that cause economic insecurity in individuals and families. Some timely causes of economic insecurity include divorce, alcohol and drug addiction, gambling, domestic violence, and bankruptcy. Divorce

Divorce is widespread in the United States and is an important cause of economic insecurity for many divorced women. As stated earlier, the poverty rate for female householders with children under age 18 and no husband present was 37.2 percent in 2008. Divorced women with minor children are an important part of this group. Economic insecurity may result from several factors. First, research studies generally show that many divorced women experience a significant decline in money income after the divorce occurs. Many divorced women are in the labor force, where women typically are paid less than men. Second, many fathers default on their child-support payments, or the payments are habitually late; the result is insufficient income for the family. Also, some older women who get a divorce do not have access to their ex-husband’s retirement plan. Third, in the majority of cases, the mother is awarded custody of minor children. As stated earlier, the financial cost of raising minor children to adulthood is substantial, and falls heavily on the mother. Also, because of child-rearing responsibilities, many divorced mothers can work only part time, thus reducing earned income. In addition, many divorced mothers do not have health insurance and can be faced with substantial uninsured medical bills if a major sickness or injury occurs. The problem of additional expenses is relevant here. Finally, divorce can have a severe emotional impact on children. Research studies show that children of divorced parents are often hurt and bewildered, experience considerable anger, underachieve in school, and have problems with relationships years after the divorce occurred. Alcohol and Drug Addiction

Substance abuse is another important cause of economic insecurity. The National Council on Alcoholism and Drug Dependence estimates that about 18 million Americans have serious alcohol problems, and another 5 to 6 million people have severe drug problems.14 Substance abuse can cause serious health problems and is an important causal factor in domestic violence, suicide, auto accidents, homicides, and child abuse. In addition, drug addiction is rampant in the United States. Millions of Americans habitually use marijuana, cocaine, crack, heroin, and other drugs. In particular, methamphetamine is a powerful drug that is widely used. Supporting a serious drug habit can cost thousands of dollars weekly, and addicts pay the high price of damaged health, dysfunctional families, loss of career opportunities, and incarceration in jail and prison. In particular, addiction to alcohol or drugs can cause severe economic insecurity

Causes

of

Economic Insecurity  13

because of (1) loss of earned income to the family, (2) poor health from excessive drinking or habitual drug use, (3) loss of a job or inability to work at a steady job, (4) an increase in broken or dysfunctional families, and (5) an increase in crime and overall deterioration in the quality of life in many neighborhoods. Gambling

Gambling problems also cause economic insecurity. Most adults who gamble do not have a gambling problem. However, the National Council on Problem Gambling estimates that 2 million (1 percent) of the adults in the United States meet the criteria for pathological gambling in a given year. Another 4 to 6 million (2 to 3 percent) are considered problem gamblers because although they do not meet the full diagnostic criteria for pathological gambling, they meet one or more of the criteria and are experiencing problems from their gambling behavior.15 Pathological gamblers are often deeply in debt and suffer disproportionately from insomnia, depression, and other stress-related diseases. Pathological gamblers often commit crimes of forgery, fraud, embezzlement, or theft. Because of their addiction, pathological gamblers may lose their jobs, their careers may be altered, and they may serve time in jail and prison. The loss of a job, high gambling-related debts, and illegal acts can result in great economic insecurity for pathological gamblers and their families. Domestic Violence

Domestic violence is another important cause of economic insecurity. Domestic violence is a leading cause of injury to women. One in three women reports being physically or sexually abused by her husband or boyfriend sometime during her life, and more than 32 million Americans are affected by domestic violence each year.16 Many battered women have low self-esteem and find it difficult to work. Since they lack the income to be self-supporting, they often remain in an abusive relationship and are exposed to great physical harm. Many battered women apply for admittance to homes or shelters that provide protection and specialized services. The home or shelter, however, may have a time limit on the length of stay. Many battered women are unemployed, and finding a job that pays a living wage to live independently can be difficult if the community is experiencing high unemployment. Also, many battered women do not have furniture and other household goods to live independently in a house or apartment, so the problem of additional expenses is also present. Personal Bankruptcy

Personal bankruptcy also causes economic insecurity. More than one million persons declare bankruptcy each year. Personal bankruptcy is due to a number of factors. First, as stated earlier, poor health is a major contributing factor: unpaid medical bills contributed to 62 percent of the personal bankruptcies in the United States in 2007. Second, the abuse of credit is a major factor in personal bankruptcy; many con-

14  Economic Security

and Insecurity

sumers use multiple credit cards, spend recklessly, rack up enormous debt, and often declare bankruptcy to avoid repayment. Harassment from bill collectors adds to the problem. Third, during the severe recession in 2008 and 2009, the housing market collapsed and foreclosures increased sharply. Many homeowners declared bankruptcy because the market value of their homes was less than the mortgage balance; other homeowners with marginal credit records declared bankruptcy because they had purchased homes they could not afford. Finally, unforeseen events can result in personal bankruptcy. Examples include the unexpected death or disability of a family head, unanticipated loss of a job during a business downswing, failure of a small business firm to survive during a severe business recession, and substantial loss of financial assets during a severe stock market decline by workers nearing retirement, which delays retirement or results in a reduced standard of living in retirement.

Concept of Social Security Many of the preceding causes of economic insecurity are addressed by social security programs in many countries. The Social Security Administration periodically publishes a four-volume series on social security programs throughout the world.17 In that report, the term “social security” refers to programs established by law that insure individuals against the loss or interruption of their earned income, and for certain expenditures arising from marriage, birth, or death. This concept also includes family allowances that some countries provide for the support of children. Individuals and families that have lost income as a result of death, disability, and old age; work-related injuries; unemployment; and sickness and maternity receive cash payments that at least partially replace the income. Programs that provide this money are called income-maintenance programs. Some countries also finance or provide direct services for hospitalization, medical care, and rehabilitation. These programs are referred to as benefits in kind. The Social Security Administration classifies the income-maintenance programs in different countries into three broad categories: (1) employment-related programs, (2) universal programs, and (3) means-tested programs.18 Under the first two categories, cash benefits are paid as a matter of right. Under the means-tested approach, benefits are based on a comparison of the individual’s income with some standard measure of need.

Employment-Related Programs Employment-related programs are social insurance programs (discussed later) that generally base eligibility for pensions and other periodic cash payments on the length of employment and self-employment. In the case of work-related injuries and family allowances, eligibility is established based on an employment relationship. As will be pointed out later, social insurance programs pay benefits based on the worker’s covered earnings and are typically financed by specific contributions from covered workers, employers, or both.

Meaning

of

Social Insurance  15

Universal Programs Universal programs provide flat-rate cash benefits to citizens and residents. There is no consideration of income, employment, or satisfaction of a means test. Universal programs generally are financed by general revenues, and benefits are paid to all persons that meet the residency requirement. In some countries, however, benefits are partly financed by contributions from workers and employers. Finally, most countries with universal programs provide a second tier of benefits that are based on the worker’s earned income.

Means-Tested Programs In addition to social security programs, most countries have means-tested programs. These programs establish eligibility for benefits by measuring the individual’s or family’s financial resources against some standard measure of need, which is typically based on a subsistence level of income. Applicants must meet a means test (also called a needs test) and show that their income and financial resources are below the standard of need established for the program. Although means-tested programs vary among countries, they have certain common features. Benefits are usually limited to low-income or poor recipients; benefits are normally approved only after an investigation of the applicant’s financial resources and needs; the benefit amount is typically adjusted to the recipient’s financial resources and needs; and the benefits are typically financed out of general revenues of government. In the United States, public assistance programs (also called welfare programs) are means-tested programs that provide cash income and other benefits to poor people who are not covered under social insurance programs. Public assistance programs are also used to supplement social insurance benefits that are inadequate for people whose financial resources are small or nonexistent, or for people with special needs. Public assistance programs are discussed in greater detail in Chapter 16.

Meaning of Social Insurance Social insurance programs are part of the overall structure of social security. Social insurance programs have distinct characteristics that distinguish them from other government programs. The following section discusses the generic characteristics of social insurance.

General Characteristics Social insurance programs have certain generic characteristics. First, they are not financed primarily out of the general revenues of government, but are financed in large part by specific contributions from covered employees, employers, or both. These contributions are usually earmarked for special funds, and the benefits, in turn, are paid from these funds. Second, the right to benefits is derived from or linked to the recipient’s past contributions or coverage under the program. The benefits and

16  Economic Security

and Insecurity

contributions generally vary among the beneficiaries based on their prior earnings. Third, most social insurance programs are compulsory: certain categories of workers and employers are required by law to pay contributions and participate in the program. Finally, eligibility requirements and benefits are usually prescribed by statute.

Definition of Social Insurance After careful study, the Committee on Social Insurance Terminology of the American Risk and Insurance Association defined social insurance as a device for the pooling of risks by their transfer to an organization, usually governmental, that is required by law to provide cash or service benefits to or on behalf of covered persons upon the occurrence of certain specified losses. To be called social insurance, the program must meet all of the following conditions:19 • Coverage is compulsory by law in virtually all instances. • Except during a transition period following its introduction, eligibility for benefits is derived, in fact or in effect, from contributions made to the program by or on behalf of the claimant, or the person as to whom the claimant is a dependent; there is no requirement that the individual demonstrate inadequate financial resources, although a dependency status may have to be established. • The method for determining benefits is prescribed by law. • The benefits for any individual are not usually directly related to contributions made by or on behalf of the individual, but instead redistribute income to certain groups such as those with low wages or a large number of dependents. • There is a definite plan for financing the benefits that is designed to be adequate in terms of long-range considerations. • The cost is borne primarily by contributions, which are usually made by covered persons, their employers, or both. • The plan is administered or at least supervised by government. • The plan is not established by the government solely for its present or former employees; social insurance programs must cover some persons other than government employees. This definition clearly shows that social insurance programs have unique characteristics that are usually not found in private insurance. Failure to recognize these differences has led to considerable confusion regarding the desirability of economic security programs. The unique characteristics of social insurance are analyzed in greater detail in Chapter 2. The following programs are considered social insurance because they meet the preceding definition: • Old-Age, Survivors, and Disability Insurance (also called Social Security or OASDI) • Medicare • Unemployment Compensation

Reducing Economic Insecurity  17

• Workers’ Compensation • Compulsory Temporary Disability Insurance • Railroad Retirement System • Railroad Unemployment and Temporary Disability Insurance The following programs are not considered social insurance because they do not meet the above definition: • Federal Employees Retirement System. This program is not social insurance because it was established solely for government employees. • Civil Service Retirement System. The plan was established by the government solely for its employees. • National Flood Insurance Program. The plan is not compulsory. • Federal Crop Insurance. The various plans are not compulsory. • Public Assistance. This is welfare, not social insurance. A stringent means test must be satisfied; benefits paid are based on need; and the cost is not borne directly by employees and their employers. • Veterans’ Benefits. The various benefits generally are financed out of general revenues; the government established the plans primarily for military personnel and ex-service members; and some benefits require that the applicant’s income be below a specified level.

Reducing Economic Insecurity Numerous public and private techniques are used in the United States to reduce economic insecurity. Some techniques aim at preventing economic insecurity by reducing or eliminating its cause. Other approaches alleviate the financial consequences after a loss occurs. Table 1.1 presents a list of selected programs and techniques that are currently used in the United States to reduce economic insecurity.

Private Economic Security Programs Individuals and families can receive protection against economic insecurity by purchasing life, health, homeowners’, and auto insurance, as well as other types of individual insurance. Savings can be accumulated for contingencies; individual retirement accounts (IRAs) can provide additional income at retirement; the earnings of other family members may be available to offset the loss of earned income, such as the earnings of an employed spouse; and individuals may return to school to upgrade their work skills to obtain a higher-paying job. Finally, financial assistance is often available from churches and private charity organizations. Individuals and families also receive protection against economic insecurity from employer-sponsored group life and health insurance plans, employer contributions to tax-advantaged retirement or 401(k) plans, and severance pay and other benefits when there is a major reduction in employment. In addition, a corporation may use certain employment-stabilization techniques, such as work-sharing arrangements. Finally,

18  Economic Security

and Insecurity

Table 1.1

Selected Programs and Techniques to Combat Economic Insecurity in the United States Private Programs and Techniques I. Individual

II. Employer

A.  Private Insurance    1. Life insurance and annuities    2. Health insurance and disability income    3. Homeowners’ insurance    4. Auto insurance B.  Private savings and investments C.  Individual retirement accounts (IRAs) D.  Earnings of other family members E.  Education to upgrade and improve job skills F.  Assistance from children, relatives, churches, and    private charity organizations

A.  Qualified retirement and profit-sharing plans B.  Defined-benefit pension plans C.  Section 401(k) plans D.  Group life insurance E.  Group health insurance (including disability income    and paid sick leave) F.  Severance pay and unemployment benefits G.  Private employment stabilization H.  Retirement plans for the self-employed

Public Programs and Techniques A.  Social insurance    1.  Old-Age, Survivors, and Disability Insurance (OASDI)    2.  Medicare    3.  Unemployment insurance and extended unemployment benefits    4.  Workers’ compensation    5.  Compulsory Temporary Disability Insurance    6.  Railroad Retirement Act    7.  Railroad Unemployment Insurance Act B.  Public assistance    1.  Supplemental Security Income (SSI) for the Aged, Blind, and Disabled    2.  Temporary Assistance for Needy Families (formerly AFDC)    3.  Medicaid    4.  General Assistance C.  Selected federal legislation to reduce economic insecurity    1.  Patient Protection and Affordable Care Act    2.  Health Care and Education Reconciliation Act    3.  American Recovery and Reinvestment Act of 2009    4.  Children’s Health Insurance Program (CHIP)    5.  Pension Protection Act of 2006    6.  Health Insurance Accountability and Portability Act of 1996    7.  National Flood Insurance Program    8.  Occupational Safety and Health Act of 1970 D.  Government policies    1.  Monetary policy to stabilize the economy and promote full employment    2.  Fiscal policy to reduce unemployment and promote economic growth    3.  Job-training programs for displaced persons    4.  Tax subsidies to expand employment E.  Other programs    1.  Veterans’ benefits    2.  Civil Service Retirement System    3.  Federal Employees’ Retirement System    4.  Services for children    5.  Food stamps    6.  Public housing    7.  Mental health programs    8.  Vocational rehabilitation    9.  Crime compensation plans    10.  Energy assistance programs    11.  Subsidized student loans    12.  Pell grants

Summary  19

self-employed individuals have access to several retirement plans with favorable tax treatment, including Keogh plans, individual 401(k) plans, simplified employee pensions (SEP), and a SIMPLE retirement plan.

Public Economic Security Plans Government combats economic insecurity in the public sector in several ways. First, social insurance and public assistance programs are used to alleviate the economic insecurity from the social risks described earlier. Second, the government may enact specific legislation to reduce economic insecurity from specific risks. Examples include enactment of Medicare in 1965 to meet the economic problem of high and uninsured medical expenses for the aged, and the Patient Protection and Affordable Care Act in 2010 to deal with the large number of uninsured in the United States and serious problems with the current health-care delivery system. Finally, government policies can be adopted to stabilize the economy and expand employment, including monetary and fiscal policies to reduce employment and stimulate economic growth, and job-training programs and tax subsidies to reduce unemployment.

Summary • Economic security can be defined as a state of mind or sense of well-being in which an individual is relatively certain that he or she can satisfy basic needs and wants, both present and future. • Economic insecurity is the opposite of economic security; the sense of well-being or state of mind that results from being relatively able to satisfy both present and future needs and wants is lacking. Instead, there is considerable worry, fear, anxiety, frustration, and psychological discomfort. The need for money is ­constant. • Economic insecurity is associated with the loss of income, additional expenses, insufficient income, and uncertainty of income. • The major causes of economic insecurity include premature death of the family head, old age, poor health, unemployment, substandard wage, inflation, natural disasters, children born outside of marriage, and personal factors. • Personal factors that cause economic insecurity include divorce, alcohol and drug addiction, gambling problems, domestic violence, and bankruptcy. • In the broad sense, the term “social security” refers to programs established by law that insure individuals against the loss or interruption of their earned income, and for certain expenditures arising from marriage, birth, or death; this concept also includes family allowances that some countries provide for the support of children. • In the United States, the Old-Age, Survivors, and Disability Income program (OASDI) is also called Social Security. • The Social Security Administration classifies the income-maintenance programs in the different countries into three broad categories: employment-related programs, universal programs, and means-tested programs. • Means-tested programs establish eligibility for benefits by measuring the indi-

20  Economic Security

and Insecurity

vidual’s or family’s financial resources against some standard measure, which typically is based on subsistence needs. Applicants for benefits must show that their income or financial assets are below the standard of need established for the programs. • Social insurance can be defined as a device for the pooling of risks by their transfer to an organization, usually governmental, that is required by law to provide cash or service benefits to or on behalf of covered persons upon the occurrence of certain specified losses. • Social insurance programs have certain generic characteristics to distinguish them from other government programs. Social insurance programs are not financed primarily out of the general revenues of government, but are financed in large part by specific contributions from covered employees, employers, or both; the right to benefits is derived from or is linked to the recipient’s past contributions or coverage under the program; benefits and contributions generally vary among the beneficiaries based on their prior earnings; most social insurance programs are compulsory; and eligibility requirements and benefits are usually prescribed by statute. • Private techniques that reduce economic insecurity include private insurance; savings and investments; individual retirement accounts (IRAs); earnings of other family members; education to upgrade and improve job skills; and assistance from children and other relatives, churches, and private charities. • Public programs and techniques to reduce economic insecurity include specific federal legislation to deal with a certain problem, monetary and fiscal policies, job-training programs, and tax subsidies.

Review Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Explain the meaning of economic security. Briefly explain the nature of economic insecurity. Identify the major causes of economic insecurity. Identify the important social problems that result in economic insecurity from personal factors. What is the meaning of “social security”? Describe the generic characteristics of social insurance programs. What is a means-tested program? Identify the major programs that are considered to be social insurance. Identify several private programs and techniques that can reduce economic insecurity. Identify several public programs and techniques that can reduce economic security.

Application Questions 1. Chris and Karen are married and own a three-bedroom home in a large midwestern city. Their son, Ken, age 20, is attending college and lives in a fra-

Internet Resources  21

ternity house. He has a part-time job to help pay for his tuition. Chris owns a local construction firm that employs five people. Karen is a statistical analyst for a large public relations firm and is often away from home several days at a time. Based on the preceding information, answer the following questions: a. Identify the major causes of economic insecurity to which Chris is e­ xposed. b. Identify the major causes of economic insecurity to which Karen is ­exposed. c. Identify the major causes of economic insecurity to which Ken is ­exposed. 2. For each of the following events, identify a private technique or public program that could reduce economic insecurity that might result from the event: a. A male construction worker, age 28, with three dependents, is seriously injured when a gust of wind blows him off the roof of the house he was working on. b. A single parent, age 28, with two minor children, is killed by a drunk driver while walking across a street to pick her children up at a local day-care center. c. A worker, age 45, loses his job when the manufacturing plant where he is employed is closed because the company outsourced his department to China. d. A female college student, age 25, incurs medical bills of $100,000 when she is treated for breast cancer. e. A home with a market value of $250,000 is damaged when a tornado destroys a large part of the city where the home is located.

Internet Resources • The Center on Budget and Policy Priorities provides considerable information on the effectiveness of federal legislation dealing with the fiscal stimulus program, tax policies, unemployment compensation, and other areas that impact economic security. Visit the site at www.cbpp.org • The Centers for Medicare & Medicaid Services (CMS) administers the Medicare program. The site provides timely information and data on the Medicare program to consumers, health-care professionals, and the media. The site also provides actuarial cost estimates for Medicare. Visit the site at www.cms.gov • The Employment and Training Administration (ETA) in the U.S. Department of Labor provides detailed information and statistics on state unemployment compensation programs. Visit the site at www.dol.gov • The Insurance Information Institute (III) provides a considerable amount of information and statistical data on earthquakes, floods, brush fires, and other natural disasters. Visit the site at www.iii.org • Medicare.gov is the official government site for people on Medicare. The site provides timely information on Medicare, nursing homes, participating physicians, Medicare publications, and prescription drug assistance programs. Visit the site at www.medicare.gov • The National Academy of Social Insurance publishes timely and important research studies and key facts on Social Security and Medicare on its Web site. Visit the site at www.nasi.org

22  Economic Security

and Insecurity

• The Social Security Administration administers the Social Security (OASDI) program in the United States. The site provides updated information on retirement, survivor, and disability benefits and recent changes in the program. Visit the site at www.socialsecurity.gov • The Social Security Advisory Board advises the president and Congress on issues relating to the Social Security Program in the United States. The site provides timely and relevant information dealing with Social Security. Visit the site at www.ssab.gov

Selected References Centers for Disease Control and Prevention. “Increase in Unmarried Childbearing Also Seen in Other Countries.” Press release, May 13, 2009. Harris, Gardner. “Out-of-Wedlock Birthrates Are Soaring, U.S. Reports.” New York Times, May 13, 2009. Himmelstein, David U., Deborah Thorne, Elizabeth Warren, and Steffie Woolhandler. “Medical Bankruptcy in the United States, 2007, Results of a National Study.” American Journal of Medicine 122, no. 8 (August 2009): 741–746. Myers, Robert J. Social Security. 4th ed. Philadelphia: Pension Research Council and University of Pennsylvania Press, 1993, Chapter 1. Social Security Administration. Social Security Programs Throughout the World: Asia and the Pacific, 2010. SSA Publication No. 13–11802, March 2011. ———. Social Security Programs Throughout the World: The Americas, 2009. SSA Publication No. 13–11804, March 2010. U.S. Census Bureau. Income, Poverty, and Health Insurance Coverage in the United States: 2008. Washington, DC, September 2009. Williams, C. Arthur, Jr., John G. Turnbull, and Earl F. Cheit. Economic and Social Security. 5th ed. New York: John Wiley & Sons, 1982, Chapter 1.

Notes 1. S.G. Sturmey, Income and Economic Welfare (London: Longmans, Green, 1959), p. 2. 2. U.S. Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2010 (Washington, DC, September 2011, Table 4). 3. U.S. Department of Health and Human Services, Administration for Children and Families, 2009/2010 HHS Poverty Guidelines (updated April 5, 2010). 4. U.S. Census Bureau, Statistical Abstract of the United States: 2012, Table 7 (131st ed.) (Washington, DC, 2011). 5. U.S. Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2010, Table 4. 6. U.S. Census Bureau Newsroom, Income, Poverty and Health Insurance Coverage in the United States: 2010, September 13, 2011. 7. David U. Himmelstein, Deborah Thorne, Elizabeth Warren, and Steffie Woolhandler, “Medical Bankruptcy in the United States, 2007: Results of a National Study.” American Journal of Medicine, 122, no. 8 (August 2009): 741–746. 8. Disability Benefits, SSA Publication No. 5 05–10029, August 2010, ICN 456000. 9. Because of a severe recession and high unemployment, federal legislation was enacted in early 2009 that provided a temporary 65 percent government subsidy to help unemployed workers purchase COBRA coverage. The maximum period for receiving the subsidy was 15 months.

Notes  23 10. “Hurricane Katrina.” In Wikipedia. Available at http://en.wikipedia.org/wiki/Hurricane_­ Katrina 11. “2010 Haiti Earthquake.” In Wikipedia. Available at http://en.wikipedia.org/wiki/2010_Haiti_ earthquake 12. Centers for Disease Control and Prevention, “Increase in Unmarried Childbearing Also Seen in Other Countries.” Press release, May 13, 2009. 13. U.S. Census Bureau, Housing and Household Economics Statistics Division, Historical Poverty Tables—Current Population Survey, Families, Table 4, September 2009. 14. The National Council on Alcoholism and Drug Dependence, Alcoholism and Drug Dependence Are America’s Number One Health Problem, Facts and Information. Available at www.ncadd.org/facts/ numberoneprob.html 15. National Council on Problem Gambling, How Widespread is Problem Gambling in the U.S.? Available at http://www.ncpgambling.org/i4a/pages/Index.cfm?pageID=3315#widespread 16. Joyful Hearts Foundation, Learn the Facts. Available at www.joyfulheartfoundation.org/ dv_learnthefacts.htm 17. Social Security Administration, Social Security Programs Throughout the World: The Americas, 2009, SSA Publication No. 13–11804, March 2010, pp. 1–4. 18. Ibid. 19. Bulletin of the Commission on Insurance Terminology of the American Risk and Insurance Association 1, no. 2 (May 1965), and 2, no. 2 (July 1966).

2 Basic Principles of Social Insurance

Student Learning Objectives After studying this chapter, you should be able to: • Explain the basic principles and characteristics of the Old-Age, Survivors, and Disability Insurance (OASDI) program. • Show how the OASDI program is insurance. • Explain how social insurance programs differ from private insurance. • Explain how social insurance programs differ from public assistance programs. • Describe the economic objectives of social insurance programs. A multitude of errors in thinking surrounds social insurance programs in the United States. This confusion is due largely to a misunderstanding of the principles and objectives of social insurance. Comparisons with private insurance are often improperly made. It is important, therefore, to analyze the basic principles and characteristics of social insurance programs so that these programs can be viewed in their proper perspective. The basic principles of social insurance can be illustrated by examining the characteristics of the Old-Age, Survivor, and Disability Income (OASDI) program, also known as Social Security. The OASDI program is the largest and most important social insurance program in the United States. In this chapter, we examine the basic characteristics of the OASDI program, whether the OASDI program is a true form of insurance, and the similarities and differences between private and social insurance. We also compare social insurance programs with public assistance programs. Finally, we conclude the chapter by discussing the economic objectives of social insurance programs.

Basic Principles and Characteristics of the OASDI Program The complete Social Security program in the United States consists of OASDI and Medicare. In this chapter, we examine only the characteristics of OASDI.1 Medicare is discussed later in Chapter 10. 24

Basic Principles

and

Characteristics

of the

OASDI Program  25

The major characteristics of the OASDI program include the following: • Compulsory program • Minimum floor of income • Emphasis on social adequacy rather than individual equity • Benefits loosely related to earnings • Right to benefits with no means test • Self-supporting contributory principle • No full funding • Benefits prescribed by law • Plan not established solely for government employees

Compulsory Program With few exceptions, the OASDI program is compulsory. This principle has been consistently followed since passage of the Social Security Act in 1935. A compulsory program makes it easier for society to protect the population against certain risks, such as premature death of the family head, insufficient income during retirement, or long-term disability. If the OASDI program were made voluntary, some individuals would elect not to be covered. As a result, the policy objective of providing a basic floor of income to all members of a defined group would not be attained.2 In addition, the OASDI program is a large program because it is compulsory, and a large system has an advantage over smaller systems. Since fewer random or accidental fluctuations in loss experience are likely to occur, the necessity of providing margins in contingency reserves is reduced.

Minimum Floor of Income The OASDI program provides only a minimum floor of income in the payment of benefits. Traditional philosophy in the United States says that individuals are primarily responsible for their own economic security. People are expected to supplement government economic security programs with their own personal program of savings, investments, and insurance. The concept of a minimum floor of income is difficult to define precisely, and some disagreement exists concerning the minimum and maximum benefits that should be paid. Generally speaking, there are three views regarding the minimum floor of income.3 First, one extreme view is that minimum benefits should be so low as to be virtually nonexistent. Second, the other extreme says that benefits should be high enough to provide a comfortable standard of living by itself, with no consideration given to other economic security programs provided by private or group methods (private insurance, group insurance, private pensions). Third, a middle view is that the minimum floor of income should, in combination with other income and financial assets, be sufficient to maintain a reasonable standard of living for the vast majority of beneficiaries. Any residual group whose basic needs are still unmet would be ­provided for by supplementary public assistance. This result is highly desirable

26  Basic Principles

of

Social Insurance

because supplementary public assistance programs are expensive to administer and also are viewed as demeaning by some beneficiaries. One important objective of social insurance programs is to keep people off welfare. As we point out later, the OASDI program is very effective in reducing the number of beneficiaries who are counted as poor.

Emphasis on Social Adequacy Rather Than Individual Equity As stated earlier, the OASDI program pays benefits based on social adequacy rather than individual equity.4 Social adequacy means that the benefits paid provide a certain standard of living to all contributors. Individual equity means that contributors receive benefits directly related to their contributions; in technical terms, the actuarial value of the benefits is closely related to the actuarial value of the contributions. The OASDI program provides benefits on a basis falling between complete social adequacy and complete individual equity, with heavy emphasis on the former. The social adequacy principle results in the payment of benefits that are heavily weighted in favor of certain groups, such as low-income groups, beneficiaries with large families, and older people near retirement when first covered under the program. The actuarial value of their benefits exceeds the actuarial value of their tax contributions. This means they receive relatively larger benefits compared with their contributions than other groups. The purpose of emphasizing social adequacy in the payment of benefits is to provide a minimum floor of income to covered groups. If certain groups received benefits actuarially equal to the value of their contributions (individual equity principle), the benefits paid would be so small for some groups (for instance, low-income groups) that the objective of providing a minimum floor of income to covered groups would not be achieved. In contrast, private insurance stresses the individual equity principle. Losses are pooled, and people with roughly the same loss-producing characteristics are grouped in the same class and pay roughly equal premiums. Private insurers have numerous underwriting classes based on identifiable loss-producing characteristics for the group and charge an appropriate premium for actual and anticipated losses. Because private insurance is voluntary, there must be equity in rating. It is considered inequitable to have one underwriting class pay a large part of the loss costs experienced by another class. Once individuals in the first group became aware that they were being overcharged to subsidize other groups, they would drop their insurance and go elsewhere to obtain the insurance at a lower price. The OASDI program and other social insurance programs, however, are different in character and goals. The primary objective of social insurance is to provide basic economic security to most people against the risks of premature death, old age, sickness and disability, and unemployment. It is only after this objective is attained that any remaining funds can be used to provide additional benefits based on individual equity.5

Basic Principles

and

Characteristics

of the

OASDI Program  27

Methods of Providing Socially Adequate Benefits

The OASDI program uses several methods to provide socially adequate benefits.6 First, as stated earlier, the benefit formula is heavily weighted in favor of lowincome groups. Second, beneficiaries with a large number of dependents receive relatively higher benefits than beneficiaries with no dependents. Finally, OASDI benefits are annually adjusted for inflation based on measurable changes in the Consumer Price Index. Since beneficiaries receive additional benefits for which they have not paid, the social adequacy principle is again reflected in the payment of benefits. Redistribution of Income Effect

Emphasis on the social adequacy principle results in a redistribution of income. As stated earlier, certain groups receive benefits that actuarially exceed the value of their contributions. In effect, these groups are undercharged for their benefits, and other groups are overcharged. This redistributes income by taking income away from one group and giving it to another. The redistribution of income under the OASDI program is necessary in order to provide socially adequate benefits to low-income groups and others groups who are unable to pay the full actuarial cost of their benefits.

Benefits Loosely Related to Earnings OASDI benefits are loosely related to earnings. This means that there is some relationship between individual equity and social adequacy. In general, the higher the worker’s average covered earnings, the greater will be the benefits. The relationship between higher average earnings and higher benefits is loose and disproportionate, but it does exist. This point will be discussed in greater detail in Chapter 5 when the benefit formula is analyzed. Paying higher benefits because of higher earnings has a number of advantages.7 First, the free enterprise system stresses economic rewards to a worker based upon personal talents and initiative. This principle is reflected in the OASDI program. A worker who earns a higher income because of personal efforts receives larger OASDI benefits. Second, paying benefits based on earnings takes into consideration different standards of living, diverse economic conditions, and price levels in different parts of the country. Work earnings generally determine the worker’s standard of living at retirement. If flat benefits were paid to everyone, the amount paid to some workers could equal or exceed their preretirement earnings, but the same amount paid to workers who had worked at higher-income levels would not provide them with meaningful economic security. Thus, benefits are more adequate for workers whose earnings have increased over time.

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Right to Benefits with No Means Test OASDI benefits are paid as a matter of right without a formal demonstration of need. A means test is used in public assistance, in which applicants must demonstrate that their income and financial assets are below some subsistence standard of living. Under the OASDI program, however, recipients have a right to the benefits with no demonstration of need, assuming the eligibility requirements are met. Contractual Right

The right to OASDI benefits clearly is not a contractual right, because no formal contract exists between the insured and the federal government. In the Fleming v. Nestor case,8 the Supreme Court held that the right to OASDI retirement benefits was not comparable to that of the holder of an annuity contract, whose right to benefits was based on contractual premium payments. A contractual right can be modified only by an agreement between two parties, so the right to OASDI benefits is not contractual, since Congress can alter, amend, and repeal the benefits without the consent of the insured. Earned Right

Another view is that the right to OASDI benefits is an earned right, because the worker has contributed to the program and has paid for the benefits during his or her working career, or someone has contributed on the worker’s behalf. Although this view is widely held by the public, it must be carefully qualified. First, the payment of OASDI contributions by itself does not give the person an unequivocal right to benefits because other eligibility conditions must also be fulfilled. Second, from a technical viewpoint, low-income groups and other groups that receive socially adequate benefits have not strictly “earned” the right to benefits, because the actuarial value of their expected benefits substantially exceeds the actuarial value of their modest tax contributions. Statutory Right

This is probably the correct view regarding the right to OASDI benefits.9 A statutory right is enforceable in the courts; and individuals can sue to enforce their right to benefits. This is a powerful right, because specific benefits established by law must be paid to eligible applicants. It should be pointed out, however, that Congress can amend or repeal any provision of the Social Security Act if public policy so demands. In the Fleming v. Nestor case cited earlier, the Supreme Court ruled that, although there were substantial property rights involved in the benefits, Congress could modify the benefits in any reasonable way, but that there was protection under the Constitution against arbitrary change on the part of Congress.

Basic Principles

and

Characteristics

of the

OASDI Program  29

Self-Supporting Contributory Principle Another important principle is that the OASDI program generally should be financially self-supporting from the payroll tax contributions of covered employers, employees, and the self-employed; interest on the trust fund investments; and revenues from the taxation of part of the OASDI benefits. The contributory-financing principle has several advantages.10 First, because covered employers, employees, and the self-employed contribute to the program, they have a greater awareness of the relationship between benefits and contributions, and the fact that increased benefits generally will require higher taxes. For example, most motorists generally do not relate the taxes paid on gasoline to the federal program for highway improvement. Likewise, most workers covered under the OASDI program would not relate the contributions they pay to the benefits received if OASDI contributions were based on something other than earnings (such as a value-added tax or sales tax). However, workers generally are more aware of the payroll tax deduction from their earnings to fund the OASDI programs, and that higher benefits require higher tax contributions. Second, the contributory principle encourages a more responsible attitude on the part of elected politicians. Congress has the right to change the OASDI program; such legislative action in a democracy ultimately depends upon the views of voters who generally dislike tax increases. As a result, members of Congress have a more responsible attitude with regard to financing the program, and know that increased benefits usually require higher taxes. If voters contribute to the OASDI program, elected politicians are more sensitive to the financing and benefit concerns of taxpayers and are less likely to expand or cut the program unwisely. Finally, most employed workers contribute to the OASDI program, which has an important psychological appeal and results in widespread acceptance of the program. Covered groups feel greater psychological security in the protection provided, and the program is less susceptible to unsound changes because of political pressure groups.

No Full Funding Although private defined-benefit pension plans stress full funding, it is not necessary for social insurance programs to be fully funded. One definition of full funding is that the accumulated OASDI trust fund assets, plus the present value of future contributions, will be sufficient to discharge all liabilities over the valuation period. OASDI actuaries make cost estimates over a 75-year projection period and even beyond. According to the 2011 Board of Trustees report, the present value of the unfunded obligations from the program’s inception for 1935 through 2085 is $6.5 trillion. The present value of the unfunded obligations for 1935 through the infinite horizon is $17.9 trillion.11 Infinite horizon means that the current OASDI program and the demographic and economic trends used for the 75-year projection period continue indefinitely. However, the combined OASDI trust fund balance at the end of 2010 totaled only $2.6 trillion. To be fully funded, a substantially higher trust fund balance would be required.

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A fully funded program is considered unnecessary for several reasons. First, because the program is expected to operate indefinitely and will not terminate in the predictable future, full funding is unnecessary. Second, since the program is compulsory, new entrants will always enter the program and pay taxes to support it. Third, the federal government can use its taxing and borrowing powers to raise additional revenues if the program has financial problems. Finally, from an economic viewpoint, full funding would require substantially higher OASDI tax contributions, which would be deflationary and cause substantial unemployment.

Benefits Prescribed by Law In the OASDI program and other social insurance programs, the benefits are prescribed by law, with the administration or supervision of the plan performed by government. The benefits or benefit formulas, as well as the eligibility requirements, are established by law. Although the federal government administers the OASDI program, other social insurance programs may be administrated at the state or local level.

Plan Not Established Solely for Government Employees The OASDI program and other social insurance programs can be distinguished from other government insurance programs, such as the Federal Employees Retirement Act or Civil Service Retirement System. A social insurance program is not a plan established by the government solely for its own employees, but is a plan for dealing with a social problem that requires government intervention. A plan established solely for government employees is not considered social insurance because the government is acting like other employers in providing employee benefits to their employees.

Is the OASDI Program Insurance? Disagreements concerning the meaning of private insurance have formed the basis of serious debate among economists, risk management and insurance professors, lawyers, politicians, and private insurers. There is no single definition of insurance. Insurance can be defined from the viewpoint of several disciplines including law, economics, history, actuarial science, risk theory, and sociology. The controversy over the meaning of insurance becomes even more intense when the OASDI program is analyzed as a form of insurance. One position, generally presented by economists, is that the OASDI program is not a true form of insurance because the program is compulsory; contracts are not issued; the actuarial relationship between benefits and contributions is imprecise; a redistribution of income is heavily stressed; and compulsory tax contributions are not the same as private insurance premiums. Instead, these economists view the OASDI programs as a massive government income maintenance program for promoting national economic security through the imposition of compulsory payroll taxes. The preceding viewpoint is misleading and incorrect. Its proponents generally ignore the important private insurance elements of pooling, fortuitous losses, risk

Is

the

OASDI Program Insurance?  31

transfer, and indemnification. Although the OASDI program differs from private insurance in several respects, it contains a number of private insurance elements. As such, the OASDI program should be correctly viewed as a form of social insurance, which contains both (1) private insurance components and (2) a strong welfare component.

Private Insurance Components The generic term “insurance” can be defined in a way that includes or excludes the OASDI program. After careful study, the Commission on Insurance Terminology of the American Risk and Insurance Association defined insurance as follows: Pooling of risk of fortuitous losses by transfer of such risk to insurers who agree to indemnify insured individuals for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risks.12

Although this definition may be unacceptable to some insurance scholars, it forms a suitable basis for determining whether OASDI is a true form of insurance. Several critical elements in the definition are worthy of discussion. They are as follows: • Pooling • Payment of fortuitous losses • Risk transfer • Indemnification for loss Pooling

Private insurance utilizes the pooling technique for meeting risk. Pooling, or combination, is a technique by which a large number of exposure units are combined or grouped so that the law of large numbers can operate to provide a substantially accurate prediction of future losses. In addition, pooling involves the spreading of losses over the entire group. The losses of individuals exposed to certain risks are pooled or averaged, and average loss is substituted for actual loss. Thus, pooling implies the prediction of future losses with some accuracy and the spreading of these losses over the group. Because of complex sociologic, economic, and demographic variables, social insurance actuaries have a more difficult task predicting future losses than do private insurance actuaries. The law of large numbers is of little practical value in predicting future long-run OASDI experience because of the difficulty of computing the standard deviations of the many variables on which the cost estimates are based. Although OASDI experience can be predicted rather closely for the short-term future, cost estimates and anticipated future losses may prove to be quite different because of the large compounding effects of variations in the many factors involved. It is questionable, however, whether application of the law of large numbers

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is necessary for a true insurance program. In an earlier study on the meaning of insurance, Irving Pfeffer argues that no line of insurance is able to meet the complete set of tests implied by the law of large numbers. This is because the universe of insurance experience is constantly changing with respect to the economic and social environment, so past loss experience may not have the same relevance with respect to future loss experience. For some insurance lines, the requirements for applying the law of large numbers can generally be fulfilled, but for other lines, few requirements can be met. Thus, Pfeffer argues that application of the law of large numbers is a sufficient condition for insurance, but not a necessary condition.13 To the extent, however, that short-run OASDI loss experience can be closely estimated by application of the law of large numbers, the OASDI program can legitimately be called insurance. Although the law of large numbers is difficult to apply to long-run OASDI loss experience, nevertheless, the pooling device involves the spreading of losses over the entire covered group. For example, the loss of earned income because of retirement can be viewed as a loss attributable to a social risk. If the retired person receives OASDI benefits, he or she can recoup part of the lost income. In effect, the loss experienced by a retired person is spread over and paid for by the group that has not yet suffered any loss—those not yet retired and still making OASDI contributions. Thus, the OASDI program utilizes the pooling technique. Some insurance scholars take the position that pooling is unnecessary for a true insurance scheme.14 However, pooling, or combination of risks, when it does exist, constitutes a legitimate insurance scheme, even though it is not a necessary condition for insurance. Since the pooling technique can be applied to the OASDI program, the program can be called a true form of insurance. Payment of Fortuitous Losses

Private insurance also involves the pooling of fortuitous losses. Fortuitous losses are unforeseen and unexpected, and ideally, they should be accidental and outside the insured’s control. Most OASDI losses are fortuitous and outside the individual’s control. For example, the family may experience economic insecurity because of the family head’s premature death, or the worker may be exposed to financial hardship because of total and permanent disability. These losses are largely fortuitous and unforeseen. Thus, both private insurance and the OASDI program treat fortuitous losses. Risk Transfer

Risk transfer is another technique for handling risk. In private insurance, a pure risk is transferred to the insurer, which is in a stronger financial position to pay losses than the individual. Risk transfer also takes place in the OASDI program. The risks associated with premature death, old age, and disability are transferred, at least partly, from the individual to the OASDI program.

Social Insurance Compared

with

Private Insurance  33

Indemnification for Loss

Private insurance indemnifies the insured for losses. Indemnification means compensation to the victim of a loss, in whole or in part, by payment, repair, or replacement. The OASDI program also involves indemnification for losses. Survivor benefits restore, at least partly, the family’s share of the deceased family head’s income; retirement benefits restore part of the earned income that is lost when a worker retires; and disability benefits indemnify people who are disabled because of accidental injuries or serious diseases. Thus, both private and social insurance indemnify insureds for losses.

Welfare Component In addition to private insurance elements, the Social Security program contains a strong welfare component. The welfare component generally can be defined as the receipt of unearned benefits; that is, the benefits received by certain groups, such as low-income beneficiaries or large families, have little actuarial relationship to the value of their OASDI tax contributions. Such groups receive OASDI benefits that actuarially exceed the value of their limited tax contributions. The welfare component is derived from the social adequacy principle by which some groups receive benefits that exceed the actuarial value of their tax contributions. As stated earlier, the relationship between OASDI benefits received and covered earnings on which the tax contributions are paid is not close. The social adequacy principle is reflected in the benefit formula in which the benefits are heavily weighted or skewed in favor of lower-income groups. In contrast, the insurance element can be defined as that portion of the benefits paid that has some actuarial relationship (in the private sense) to the covered person’s average earnings and the payroll tax contributions paid on those earnings. In social insurance, the relationship between the benefits received and the contributions paid, of course, is not as close as that found in private insurance. Nevertheless, some relationship exists. In summary, the OASDI program generally meets the definition of insurance adopted by the Commission on Insurance Terminology and can be considered a type of insurance. Two critical elements normally found in any insurance program—pooling and risk transfer—are present in the OASDI program. From this perspective, the OASDI program is insurance. But it should not be viewed as pure insurance, since a strong welfare component is also embodied in the benefit structure.

Social Insurance Compared with Private Insurance Considerable confusion about the difference between social and private insurance arises from the application of private insurance standards to social insurance. Social insurance and private insurance are substantially different in characteristics and goals, and identical performance standards should not be used to judge them. As an example of the error of noncomparable performance standards, a Honda motorbike and a Rolls Royce automobile are both machines, but if the same efficiency test, such as gasoline mileage, is used to evaluate them, the motorbike would be judged a superior

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machine—a dubious conclusion at best. The error of noncomparable performance standards has been committed. As such, social insurance and private insurance should not be judged by the same standards.15 Applying private insurance standards to social insurance is also inappropriate because the fallacy of composition may nullify such comparisons. What is true for private insurance may be incorrect when applied to social insurance. For example, private insurance stresses individual equity, whereas social insurance must emphasize the social adequacy principle. The fallacy of composition is committed if one contends that, because private insurance stresses individual equity, social insurance must also stress individual equity.

Similarities Social insurance and private insurance are similar in many respects. First, both social insurance and private insurance are based on risk transfer and the pooling of losses. Second, both have provisions that relate to coverage, benefits, and financing. Third, both require mathematical calculations to determine benefit amounts and to estimate future loss costs. Both require the payment of contributions and premiums sufficient to meet the estimated costs of the programs. Also, both provide specific benefits without a formal means test. Finally, both benefit society as a whole in providing economic security.

Differences The major differences between social and private insurance are as follows: Social Insurance:

Private Insurance:

  1 Compulsory

Generally voluntary



  2 Minimum floor of income protection Larger amounts, depending on individual   desires and ability to pay   3 Emphasis on social adequacy (welfare aspect) Emphasis on individual equity   (insurance element)   4 Benefits prescribed by law can be changed Benefits based on legal contract   (statutory right)   (contractual right)   5 Government monopoly or limited competition

Competition

  6 Costs more difficult to predict

Costs more readily predictable

  7 Full funding not needed because of compulsory Full funding emphasized in defined-benefit   contributions from new entrants and because   pension plans   the program is assumed to last indefinitely   8 No underwriting (except workers’ compensation)

Individual or group underwriting

  9 Diverse differences of opinion regarding goals Opinions generally more uniform regarding   and objectives   goals and objectives 10 Investments generally in obligations of federal Both private investments and government   government   investments 11 Taxing power available to combat erosion Greater vulnerability to inflation, except   by inflation   some newer insurance products have   an inflation protection option

Social Insurance Compared

with

Private Insurance  35

The first three items in this comparison are self-explanatory and have already been covered. In item four, social insurance benefits are established by laws that can be changed; a statutory right to benefits exists. However, in private insurance, benefits are established by a legal contract enforceable in the courts; a contractual right to benefits exists. In social insurance, a contract is unnecessary. The terms are based on provisions in the law and on administrative regulations to enforce the law. It is administratively difficult to provide answers in the statutes for each set of circumstances. Private insurance, however, is generally voluntary, and people cannot be forced to buy insurance. Thus, the contractual provisions and definitions must be stated clearly in the policy. Finally, the advantages of a legally enforceable contract may be overemphasized in providing economic security. Even though a contract exists, the insurance protection may be inadequate, limited, or very costly. Many private insurance contracts can be canceled, contract provisions can be changed, or premiums can be increased. In the last analysis, the economic security provided by a private contract depends upon the continued existence and financial strength of the insurer. If the insurer becomes bankrupt, the economic security provided by the legal contract may be lost or reduced. Also, government may have a monopoly or limited competition in social insurance, whereas competition from other insurers prevails in private insurance. A monopolistic government insurer may be sound public policy. Since social insurance programs are usually compulsory, competitive selling costs can be eliminated or reduced by a monopoly insurer; moreover, the public may consider it undesirable for profit to accrue to private insurers because of a compulsory program made possible by governmcnt.16 Another difference is that prediction of costs in social insurance is more difficult and less precise than in private insurance. OASDI actuaries make cost estimates over a seventy-five-year projection period, and even beyond. Social insurance actuaries must also work with economic, demographic, and sociological variables, such as births, deaths, marriages, employment, unemployment, disability, retirement, average wage levels, benefit levels, interest rates, and numerous additional factors that make long-run prediction of costs difficult. In addition, social insurance retirement plans (e.g., OASDI) may not be fully funded, whereas private defined-benefit pension plans stress fully funded programs. Also, individual underwriting is not used in social insurance, whereas underwriting is an important function in private insurance. Individual underwriting is inappropriate in social insurance because the objective is to provide a base of economic security to the insured; this means that most of the population should be covered. In private insurance, however, underwriting is necessary because the objective is to insure profitable risks. Another difference is that in social insurance, serious disagreement may exist over the method of financing, benefit levels, eligibility requirements, groups to insure, the role of government, and numerous other factors. Opinions and objectives regarding private insurance programs generally are more uniform. Also, social insurance trust funds generally are invested in the obligations of the federal government, typically government bonds. In contrast, private insurers invest in a wide variety of private securities, including stocks, bonds, commercial real estate, mortgages, derivatives, as well as government bonds.

36  Basic Principles

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Social Insurance

Finally, the government’s taxing powers can more readily overcome the negative impact of inflation on social insurance programs. During inflationary periods, social insurance benefits may be increased, thereby providing beneficiaries some relief against higher prices. In private insurance, if the benefits are fixed, they are more vulnerable to inflation. However, many newer private insurance products provide an inflation option (e.g. long-term care insurance).

Social Insurance Compared With Public Assistance Although clear-cut differences between social insurance and public assistance are difficult to define precisely, certain dissimilarities appear. They are in the following areas:17 • Means test • Method of financing • Prediction of eligibility requirements and benefit amounts • Number of participants • Stigma attached to benefits

Means Test Social insurance programs never require a means test; public assistance always involves a means test. Applicants for public assistance benefits must show that their income and financial assets are below certain specified levels based on the means test that a state adopts, which is typically a subsistence level of living. The benefit amount in public assistance is based on the extent of the applicant’s demonstrated need. In social insurance, benefits are typically related to the worker’s earnings. For low- income individuals, public assistance may also be necessary to supplement social insurance benefits if the benefits are inadequate, or if there are emergencies or special needs that require additional benefits.

Method of Financing Social insurance benefits are typically financed out of specifically earmarked taxes. Public assistance benefits are usually financed out of the general revenues of government. Also, in public assistance, the benefit recipient does not make specific contributions to the program before he or she is eligible for benefits, and there is no relation between the benefits received and the contributions made, since the funds are usually derived from general revenues.

Prediction of Eligibility Requirements and Benefit Amounts Benefit amounts are generally predictable in social insurance. Benefit amounts, however, are more difficult to predict in public assistance. In public assistance, the recipient’s benefit is based on the extent of demonstrated need, and there is considerable variation among the states concerning the concept of need, allowable financial

Economic Objectives

of

Social Insurance Programs  37

assets, and the standard of living reflected in the means test that states use. Thus, prediction of benefit amounts in public assistance is more difficult. For these reasons, few people consider the availability of public assistance cash benefits in their economic security plans.

Number of Participants All participants in social insurance programs are the insureds; only a small percentage of the participants are actually beneficiaries at any given time. However, in public assistance, the direct participants are only the people who receive benefits. Thus, more people participate in social insurance than in public assistance.

Stigma Attached to Benefits There is no stigma or shame attached to the receipt of social insurance benefits; recipients have a statutory right to the benefits if the eligibility requirements are met. In contrast, many eligible people do not apply for welfare benefits because of a means test, which some consider demeaning. Since no stigma is attached to social insurance benefits, relatively few eligible participants refuse to make a claim.

Economic Objectives of Social Insurance Programs From an economic viewpoint, social insurance programs have several important objectives:18 • To provide basic economic security to the population • To prevent poverty • To provide stability to the economy • To preserve important economic values

Provide Basic Economic Security to the Population The primary objective of social insurance is to provide basic economic security to most people against the risks of premature death, old age, sickness and disability, and unemployment. As indicated in Chapter 1, these events cause economic insecurity because of the loss of earned income and additional expenses. Social insurance programs should provide a layer or a base of income protection to the population. In this context, basic economic security means that the social insurance benefit, along with other sources of income and other financial assets, should be sufficiently high to provide at least a minimum standard of living to the great majority of the population.

Prevent Poverty Although this is not the only objective, social insurance programs in their operations prevent a considerable amount of poverty. In particular, the OASDI program is ex-

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tremely effective in reducing the number of beneficiaries from sinking into poverty. In 2010, the poverty rate for the elderly, age 65 and over, was 9 percent. Without Social Security, an additional 14 million seniors would be poor, and the poverty rate would have increased sharply, to about 45 percent.19

Provide Stability to the Economy Another objective of social insurance is to enhance and contribute to the nation’s economic stability. This means that the programs should influence consumption, saving, and investment in a desirable way and should tend to move in a desired countercyclical direction against the business cycle. For example, unemployment compensation benefits are especially sensitive to business downswings and tend to inject additional funds into the economy during business recessions, thereby maintaining personal income and consumption spending. In addition, the methods of financing the programs should also contribute to economic stability. Although economic stability considerations are important in social insurance, they must never overshadow and override the primary objective of providing basic economic security to individuals and families against the widespread social risks confronting them. Economists often evaluate social insurance programs in terms of their macroeconomic impact on the economy, and often view as secondary the important objective of providing a base of income protection to individuals and families against major social risks.

Preserve Important Economic Values A final objective of social insurance is to preserve important economic values, which include the promotion of the desirable qualities of personal incentives, initiative, and thrift. Social insurance programs reflect the concept that a person’s level of economic security should arise out of work, and that the worker’s right to benefits, benefit amounts, and benefits received by the family should be related to work earnings. Thus, basing eligibility on a demonstration of work and paying benefits related to the worker’s wage is consistent with commonly held economic values in the United States. Moreover, social insurance benefits are paid regardless of income from savings, private pensions, and financial investments. Thrift is thereby promoted, since workers are encouraged to supplement the basic layer of protection by a personal program of savings, investments, and private insurance.

Summary The OASDI program has certain characteristics that distinguish it from other government programs. The major characteristics include the following: • Compulsory program • Minimum floor of protection • Emphasis on social adequacy rather than individual equity

Review Questions  39

• Benefits loosely related to earnings • Right to benefits with no means test • No full funding • Benefits prescribed by law • Plan not established solely for government employees • Although the OASDI program has different characteristics and goals than private insurance, it is a true form of insurance nevertheless. The OASDI program contains the private insurance elements of pooling, paying for fortuitous losses, risk transfer, and indemnification. However, the program also has a strong welfare component in its benefit structure. • Social insurance and private insurance have certain similarities. Both forms of insurance have pooling; risk transfer; provisions that pertain to coverage, benefits, and financing; tax contributions and premium payments to pay estimated costs; receipt of benefits without a formal means test; and benefit society as a whole. • Social insurance and private insurance, however, differ in many respects. Social insurance programs are compulsory, provide only a minimum floor of income, emphasize social adequacy, and benefits are prescribed by law. In contrast, private insurance is generally voluntary, makes available higher benefits depending on individual desires and ability to pay, emphasizes individual equity, and benefits are based on a legal contract. There are other differences as well. • Social insurance programs and public assistance programs have unique differences. Social insurance programs never require a means test; public assistance always involves a means test. Social insurance benefits are typically financed out of specifically earmarked taxes; public assistance benefits are usually financed out of the general revenues of government. More people participate in social insurance programs than in public assistance. Finally, there is no stigma associated with the receipt of social insurance benefits; in contrast, many eligible people do not apply for public assistance because of a means test, which may be demeaning. • Social insurance programs have important economic objectives. The programs provide a base of economic security to the population, prevent poverty, provide stability to the economy, and preserve important values.

Review Questions 1. Explain the three views concerning the meaning of a minimum floor of protection under the OASDI program. 2. Explain the principle of social adequacy. Why is social adequacy emphasized in the OASDI program? 3. Why do private insurers emphasize individual equity in the payment of ­benefits? 4. Explain why a fully funded OASDI program is considered unnecessary. 5. Briefly explain the advantages of a compulsory OASDI program.

40  Basic Principles

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6. Explain the advantages of relating the benefit amounts under the OASDI program to the worker’s earned income. 7. Is the OASDI program insurance? Explain your answer. 8. Explain the major differences between social insurance programs and private insurance. 9. Explain the major differences between social insurance programs and public assistance. 10. Briefly explain the economic objectives of social insurance programs.

Application Questions 1. The OASDI program and private life insurance have both similarities and differences. Compare the OASDI program with private life insurance with respect to each of the following: a. Legal requirement to obtain insurance coverage b. Selection of benefit amounts c. Method of financing d. Relationship between contributions or premiums to benefits received e. Right to benefits 2. Social insurance programs are fundamentally different from public assistance programs. Compare social insurance with public assistance with respect to each of the following: a. Right to benefits b. Method of financing c. Estimation of benefit amounts d. Number of participants e. Relationship between benefits and contributions

Internet Resources • The Center on Budget and Policy Priorities provides considerable information on the effectiveness of federal legislation dealing with the OASDI and Medicare programs, tax policies, unemployment compensation, and other areas that impact economic security. Visit the site at www.cbpp.org • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on Social Security and Medicare on its Web site. Visit the site at www.nasi.org • Social Security Online is the official Web site for the Social Security Administration, which administers the Social Security (OASDI) program in the United States. The site provides updated information on retirement, survivor, and disability benefits and recent changes in the program. Visit the site at www.socialsecurity .gov • The Social Security Advisory Board advises the president and Congress on issues relating to the Social Security program in the United States. The site pro-

Notes  41

vides timely and relevant reports dealing with Social Security. Visit the site at www.ssab.gov • The National Commission to Preserve Social Security & Medicare has as its goal to protect, preserve, promote, and ensure the financial security, health, and well-being of current and future generations of older Americans. The organization issues timely articles and studies on the current Social Security and Medicare programs. Visit the site at www.ncpssm.org

Selected References Myers, Robert J. Social Security. 4th ed. Philadelphia: Pension Research Council and University of Pennsylvania Press, 1993. Chapter 2. National Academy of Social Insurance. Social Security: An Essential Asset and Insurance Protection for All. Social Security Brief no. 26, February 2008. ———. “The Role of Benefits in Income and Poverty.” This online source book is periodically updated to highlight key facts about Social Security. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office, 2011. U.S. Census Bureau. Income, Poverty, and Health Insurance Coverage in the United States: 2010. Washington, DC, September 2011. Van de Water, Paul N., and Arloc Sherman, Center on Budget and Policy Priorities. Social Security Keeps 20 Million Americans Out of Poverty: A State-by-State Analysis, August 11, 2010. Williams, C. Arthur, Jr., John G. Turnbull, and Earl F. Cheit. Economic and Social Security. 5th ed. New York: John Wiley & Sons, 1982.

Notes 1. The basic principles of social insurance programs are discussed in Robert J. Myers, Social Security. 4th ed. (Philadelphia: Pension Research Council and University of Pennsylvania Press, 1993), Chapter 1. See also C. Arthur Williams, Jr., John G. Turnbull, and Earl F. Cheit, Economic and Social Security. 5th ed. (New York: John Wiley & Sons, 1982). Chapter 1. 2. Ibid, p. 11. 3. Myers, Social Security, p. 26. 4. The classic paper in the professional literature on the social adequacy principle is Reinhard A. Hohaus, “Equity, Adequacy, and Related Factors in Old-Age Security.” In Social Security: Programs, Problems, and Policies, ed. William Haber and Wilbur J. Cohen (Homewood, IL: Richard D. Irwin, 1960), pp. 61–63. 5. Ibid. 6. Margaret S. Gordon, The Economics of Welfare Policies (New York and London: Columbia University Press, 1963), p. 56. 7. Eveline M. Burns, Social Security and Public Policy (New York: McGraw-Hill, 1956), pp. 38–41. 8. Flemming v. Nestor, 363 US. 603 (1960). 9. Arthur J. Altmeyer, The Formative Years of Social Security (Madison: University of Wisconsin Press. 1966), pp. 227–228. 10. A discussion of the advantages of the contributory principle and other principles followed in the OASDI program can be found in Charles I. Schottland, The Social Security Program in the United States. 2nd ed. (New York: Appleton-Century-Crofts, 1970).

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11. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2011), Table IV.B6, p. 66. 12. Bulletin of the Commission on Insurance Terminology of the American Risk and Insurance Association 1, no. 4 (October 1965): 1. 13. Irving Pfeffer, Insurance and Economic Theory (Homewood, IL: Richard D. Irwin, 1956), p. 43. 14. Ibid., p. 185. 15. The major similarities and differences between private insurance and social insurance can be found in Myers, Social Security, Chapters 1 and 2; Williams, Turnbull, and Cheit, Economic and Social Security, pp. 8–15; and C.A. Kulp, “Social and Private Insurance—Contrasts and Similarities.” In Readings in Property and Casualty Insurance, ed. H. Wayne Snider (Homewood, IL: Richard D. Irwin, 1959), pp. 27–35. The following discussion is based on these sources. 16. Workers’ compensation is a major exception to a government monopoly. Although state ­workers’ compensation laws are compulsory, private insurers underwrite a large part of the business. Thus profits can accrue to private insurers. 17. Williams, Turnbull, and Cheit, Economic and Social Security, pp. 7–8. 18. Robert M. Ball, “Some Reflections on Selected Issues in Social Security,” in Old-Age Income Assurance, A Compendium of Papers on Problems and Policy Issues in the Public and Private Pension System, Part I: General Policy Guidelines, Subcommittee on Fiscal Policy of the Joint Economic Committee, 90th Congress, 1st sess. (Washington, DC: U.S. Government Printing Office, 1967), pp. 49–51. 19. U.S. Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2010 (Washington, DC, September 2011), Table 4, p. 15, p. 22.

3 Problem of Premature Death

Student Learning Objectives After studying this chapter, you should be able to: • Explain the definition of premature death. • Explain the costs that result from premature death. • Explain the financial impact of premature death on different types of families, including single people, single-parent families, traditional families, two-income families, sandwiched families, and blended families. • Explain the impact of premature death on the family before and after a terminally ill family head dies. • Identify the major approaches for reducing economic insecurity resulting from premature death. In this chapter, we begin our study of the first of several economic problems that can cause great economic insecurity to families—premature death. Premature death has declined in relative importance over time as a major cause of economic insecurity because of improvements in medical science and a longer life expectancy. Nevertheless, it merits serious study because some family heads die prematurely. As a result, surviving family members may experience economic insecurity and a decline in their standard of living. More specifically, in this chapter, we discuss the definition of premature death, the economic impact of premature death on the various types of families in the United States, and the various approaches for reducing economic insecurity from premature death.

Definition of Premature Death Premature death can he defined as death of a family head with unfulfilled financial obligations, such as dependents to support, children to educate, a mortgage to be paid off, and other installment debts. Premature death can cause serious financial 43

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problems for the surviving family members because their share of the deceased family member’s earned income is lost forever. If replacement income from other sources is inadequate, and the family’s savings and other financial assets are also inadequate, the surviving family members will be exposed to great economic insecurity. Finally, in general, premature death causes economic insecurity only if the deceased family head has dependents or dies with large unsatisfied financial obligations. Thus, the death of a child, age 7, is not regarded as being premature in the economic sense.

Costs of Premature Death Numerous costs, both economic and noneconomic, are associated with premature death. First, the human life value (see below) is lost to the family: the family’s share of the deceased’s future income is lost forever. Second, additional expenses may be incurred because of burial costs, uninsured medical bills, probate costs, and estate and inheritance taxes. Third, the family may be uncertain regarding the continuation and amount of future income. Fourth, because of insufficient income, the family could experience a reduction in its standard of living. Finally, certain noneconomic costs are also incurred, such as the emotional grief of a surviving spouse and dependents, loss of a parental role model, and counseling and guidance for the children during their critical formative years.

Loss of Human Life Value The loss of human life value by premature death can be enormous, especially if death occurs at a relatively young age. The human life value can be defined as the present value of the family’s share of the deceased breadwinner’s earnings. In its simplest form, the human life value can be calculated by the following steps: • Estimate the individual’s average annual earnings over his or her productive lifetime. • Deduct federal and state income taxes, Social Security taxes, life and health insurance premiums, and the costs of self-maintenance. The remaining amount is used for the family. • Determine the number of years from the person’s present age to the contemplated age of retirement. • Using a reasonable discount rate, determine the present value of the family’s share of earnings for the period determined in the previous step. For example, assume that a family head, age 27, is married and has two dependents. The worker earns $40,000 annually and plans to retire at age 67. (For the sake of simplicity, assume that earnings remain constant.) Of this amount, $15,000 is used for federal and state taxes, life and health insurance premiums, and the worker’s personal needs. The remaining $25,000 is used to support the family. Using a conservative discount rate of 5 percent, the present value of 40 annual payments of $1 at the end of each year is $17.16. Therefore, the worker has a human life value of

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$429,000 ($25,000 x $17.16 = $429,000). This sum represents the family’s share of the deceased family head’s future earnings, which is lost forever by premature death. The illustration clearly indicates that the loss of the human life value is a monumental loss.

Leading Causes of Death It is also worthwhile to examine the leading causes of death in the United States. The three leading causes of death for all ages are heart disease, cancer, and strokes (cerebrovascular diseases). These three causes accounted for the majority of deaths in 2007.1 The leading causes of death at the younger ages are dramatically different. The three leading causes of death for ages 15–24 are accidents, primarily auto accidents; homicide; and suicide.2 These three causes accounted for the majority of the deaths for this age group in 2007. In particular, homicide and suicide are significant causes of death at the younger ages and vividly highlight the violence and mental unrest experienced by many younger people today. Many deaths at the younger ages are alcohol or drug related.

Declining Problem of Premature Death The economic problem of premature death has declined substantially because of an increase in life expectancy over time. Life expectancy is the average number of years of life remaining to a person at a particular age. According to the Centers for Disease Control and Prevention, life expectancy at birth in the United States increased to a record high of 78.2 years in 2009.3 In contrast, in 1979, life expectancy at birth was only 70.8 years, or 9.5 percent lower. Life expectancy has increased over the past century because of major breakthroughs in medical science, rising real incomes and economic growth, and improvements in public health and sanitation.

Lower Life Expectancy Compared with Foreign Nations Although life expectancy at birth in the United States has increased over time, the United States ranks poorly when compared with other industrialized countries. For females, in 2008, the United States ranked 17th in life expectancy at birth out of 24 nations for which data are available—behind Japan, Germany, and most of Europe. For males, the United States also ranked 14th out of 24 nations in 2008.4 The poor showing is due to several factors: • Obesity is a major factor: more than one-third of U.S. adults and 17 percent of U.S. children are obese, which results in coronary heart disease, diabetes, cancer, hypertension, and other diseases.5 • The lifestyle of Americans generally is not conductive to longevity. Americans tend to overeat, diets are high in saturated fat, and millions of Americans lead sedentary lives and fail to exercise.

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• Millions of Americans lack health insurance and may not receive needed medical care. • Blacks and other minority groups have a shorter life expectancy, which pulls down the average. • Infant mortality rates are relatively high when compared with many industrialized countries. The infant mortality rate is the number of infant deaths per 1,000 live births. The infant mortality rate in the United States is relatively high when compared with Europe. Of 31 countries in Europe, the United States ranked 30th in infant mortality in 2005. The major cause of the high infant mortality rate in the United States is the very high percentage of preterm births (birth before 37 completed weeks of gestation).6

Economic Impact of Premature Death on the Family Any analysis of premature death must first consider the changing composition of the family. In addition, any analysis of premature death must also consider the financial impact on the family both before a terminally ill family head dies and after death occurs.

Changing Family Composition The composition of the family as we know it has changed over time. As a result, the financial impact of premature death on families is not uniform, but is more severe for certain categories of families than for others. Single People

The number of single people has increased dramatically in recent years. Young adults are postponing marriage, often beyond age 30, and many young and middle-aged adults are single because of divorce. Also, some older persons are single once again because of the death of their spouse. In general, the death of a single adult who has no dependents to support or outstanding financial obligations is not likely to cause a problem of economic insecurity for others. Single-Parent Families

The number of single-parent families with children under age 18 has increased in recent years because of the large number of children born outside of marriage, divorce, legal separation, death of a spouse, or incarceration of the father. Most single-parent families are headed by females. This is due to several factors. Many single mothers receive custody of the children, or the fathers may be absent because of divorce, separation, incarceration, or death. Also, in most cases today, the father does not marry the unwed single mother and is not the family head. Premature death of the family head in a single-parent family can cause great economic insecurity for the children. Although most single mothers work, their earnings

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Family  47

may be insufficient for attaining a reasonable standard of living. In addition, an unprecedented number of children now live in single-parent families, and many of these children do not receive any financial support from the other parent, or the financial support is inadequate or paid sporadically. As a result, many of these families live in poverty. The poverty rate for female householders with children under age 18 and no husband present was 37.2 percent in 2008.7 Premature death of the family head can only aggravate and intensify the poverty and economic insecurity that the children are already experiencing. Traditional Families

Traditional families are families in which only one parent is in the labor force, and the other parent stays home to take care of dependent children. In the past, the father was employed outside the home and the mother stayed at home to care for the children. The traditional family, however, has declined in relative importance over time. Today, most married women with minor children are in the labor force and are employed. Nevertheless, some parents prefer to stay home to care for their minor children. Premature death can cause great economic insecurity in families with children where only one spouse works. This is especially true for fathers who are employed outside the home. In the majority of cases, the husband dies first. Because of a longer life expectancy, the majority of married women with children survive their husbands by several years. Because of premature death of the husband, widows who are not in the paid labor force must often adjust their standard of living downward, and the period of financial adjustment can be painful. Many husbands die with outstanding financial obligations and debts and own insufficient amounts of life insurance to reduce or prevent this financial readjustment. Some widows who are not in the labor force may be forced to work to supplement the family’s income, and this can create additional problems. Efforts to work full time, especially when there are preschool children, often result in a severe drain on the widow’s time, energy, and nervous system. In addition, intense emotional grief only aggravates the financial problem. Two-Income Earners

Families in which both spouses work outside the home have largely replaced the traditional family in which only one spouse is in the paid labor force. In two-income families with minor children, the death of one income earner can cause considerable economic insecurity for the surviving family members because both incomes are necessary to maintain the family’s standard of living. The combined income of both spouses allows the family to maintain a much higher standard of living than if only one spouse works. If a working spouse dies, the standard of living may be reduced if the deceased has inadequate life insurance or savings, or replacement income from other sources is inadequate. However, in the case of two-income families without children, premature death of one income earner is unlikely to cause economic insecurity to the surviving spouse. The other spouse is already in the labor force and is providing for his or her own

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­ nancial support. Moreover, couples with no children do not incur the cost of providing fi a college education for the children. Thus, although the death of one working spouse can cause serious emotional problems and grief for the surviving spouse, premature death is not likely to cause economic insecurity. Blended Families

The number of blended families has also increased. A blended family is one in which a divorced or surviving spouse with children remarries, and the new spouse also has children. Both spouses may be working and in the labor force at the time of remarriage. Death of a working spouse in a blended family can cause considerable economic insecurity to the surviving dependents. Blended families with several children from two marriages are often faced with the problem of high child-rearing costs and other living expenses that accompany large families. The death of one working spouse can result in a reduction in the family’s standard of living since the family’s share of that income is lost. Moreover, in many blended families, older children are present from the previous marriage, and additional children are born out of the new marriage. As a result, both spouses are faced with expenses that extend over a longer time period. As a consequence, funds for the children’s college education or for retirement may be limited. The premature death of a working spouse in a blended family can only aggravate the financial problems of the surviving spouse in such a situation. Sandwiched Families

A sandwiched family is one in which a son or daughter with children provides financial support or services to an elderly parent or parents. The middle generation is “sandwiched” between the younger generation (children) and the older generation (parents). Premature death of a working spouse in a sandwiched family can cause considerable economic insecurity. Both children and parent(s) depend on the son or daughter for financial support. Premature death causes a loss of financial support and exposes the surviving dependents to economic insecurity.

Impact Before Death Occurs Some premature deaths occur suddenly. A family head may die suddenly from a heart attack, auto accident, plane crash, drowning, homicide, or other cause. However, in the majority of cases, a worker with a terminal illness is sick or disabled over a period of months or even years before the death occurs. During the period prior to death, the family may experience a serious disruption of normal living patterns, reduced employment opportunities, a reduction in family income, substantial medical expenses, and possible loss or reduction of employee benefits. In addition, many spouses are inadequately prepared when a premature death occurs. Thus, any analysis of premature death must also consider the financial impact on the family before a terminally ill family head dies, as well as after the death occurs.

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Disruption of Normal Living Patterns

When a family head is terminally ill, the family’s normal living patterns are often seriously disrupted. One spouse may have to perform the household duties formerly performed by the other. Family meals may be irregular, which further disrupts the normal household schedule. If the terminally ill family head is in a hospital, and small children are present, the spouse must hire a babysitter or make other arrangements in order to visit. In addition, the healthy spouse may have intense negative feelings of resentment, anger, guilt, or loneliness. Finally, there may be a serious lack of open communication between the couple concerning the illness. Reduced Employment Opportunities

A serious health problem can also reduce the employment opportunities for a family head. Opportunities for promotion and advancement in a position may be limited; the number of hours of work may be reduced; the worker may be forced to shift to a less demanding but lower-paying job; the impairment may be so severe that the worker is forced to retire early; and there is a complete loss of earned income if the impaired worker cannot work at all. Decline in Family Income

A terminal illness or disability of extended duration often results in a reduction in family income before death occurs. The reduction can be especially severe in twoincome families if one working spouse is terminally ill, since the replacement income from all sources may restore only part of the lost earnings. In particular, replacement income from private sources is likely to be inadequate if a terminally ill worker is forced to withdraw from the labor force. Although the majority of workers are covered under group short-term disability income plans or paid sick-leave plans of large employers, the cash benefits typically replace less than 100 percent of lost earnings. Also, paid sick-leave plans have limits on the number of sick-leave days that workers can earn each month. The number of sick-leave days may be inadequate over an extended period of disability before the family head dies. In addition, many workers are not covered under group long-term disability income plans that pay 50 percent or more of the disabled worker’s earnings up to age 65 and even beyond if the worker is totally disabled. To be eligible for Old-Age, Survivors, and Disability Insurance (OASDI) disability-income benefits, sick or disabled workers must be disability insured, satisfy a five-month elimination period, and be unable to perform any substantial gainful work in the economy. Some terminally ill workers may die before these requirements are met. Finally, many small firms do not provide health insurance or disability-income insurance to their employees because of cost. As a result, the family of a terminally ill worker employed by a small employer may be exposed to severe economic insecurity before the worker dies because disability income benefits are not being paid.

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Loss or Reduction of Employee Benefits

A terminally ill worker may also lose a substantial amount of money due to the loss or reduction of employee benefits. Employee benefits are an important part of the total wage package and can increase hourly or monthly earnings by 20 to 40 percent, or even more, depending on the employer. The loss of employee benefits can be substantial. If full vesting in a qualified employer-sponsored retirement plan, such as a 401(k) plan or a defined contribution retirement plan, has not been attained, a terminally ill person can lose part or all of the employer’s contributions; retirement benefits may also be reduced because the retirement benefits in defined-contribution plans are related to the worker’s earned income; employer contributions under a profit-sharing or thrift plan may also be lost; and unless there is some provision for continuing group insurance during a long illness, group life and health insurance benefits might be lost as well. Catastrophic Medical Expenses

Many families with a terminally ill family head also incur catastrophic medical expenses that can aggravate the problem of economic insecurity. During an extended illness or disability, it is not uncommon for such families to incur medical bills of $100,000, $200,000, or more. If the family lacks major medical insurance, it is exposed to great economic insecurity during an extended terminal illness of a family head. The problem of paying catastrophic medical bills could decline in the future as the provisions of the 2010 Affordable Care Act become effective and implemented. The new law prohibits lifetime limits on medical expense policies, which have forced many individuals with high medical bills to declare bankruptcy. As a result, the problem of paying for catastrophic medical bills should decline in the future. Inadequate Preparation for Death

Many spouses are inadequately prepared for a premature death. Financial planning prior to the death of a family head is often inadequate and incomplete. A family head might die without a will; the couple might not have discussed the need for life insurance protection and investment of the death proceeds; and in families where only one spouse handles the family funds, the surviving spouse may have difficulty in money management. Finally, many surviving spouses have inadequate knowledge of OASDI survivor benefits prior to the deceased’s death. Thus, many surviving spouses are inadequately prepared to become widows or widowers. In summary, for many families, economic insecurity from premature death does not occur suddenly but begins long before a family head actually dies. In the professional literature on economic insecurity, the risks of premature death, catastrophic medical costs, and unemployment are often analyzed separately. It must be recognized, however, that all three risks may be simultaneously present in the premature death problem, and any attack on premature death must also consider protection against the other risks that accompany the problem.

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Impact After Death Occurs After a death occurs, the surviving spouse is often confronted with problems of loneliness and grief, payment of final medical and funeral expenses, inadequate life insurance proceeds, and a reduction in family income. Loneliness and Grief

The surviving spouse often experiences intense emotional suffering and grief. Many surviving spouses indicate that loneliness is the most serious problem they must face. Most feel a deep sense of loss and lack of companionship after the death of a husband or wife. A painful period of psychological readjustment is often necessary. During this readjustment period, many spouses feel bitter, angry, and numb. In addition, children can experience feelings of guilt and remorse after a parent dies. Inadequate Life Insurance

A terminally ill family head often owns an inadequate amount of private life insurance. In many cases, a family head may die uninsured, or the amounts paid to the family are relatively low. One study by LIMRA International showed that the average amount of life insurance carried by households with any life insurance was $279, 900 in 2010, which would replace an average of 3.5 years of household income. However, because averages are distorted by extreme values, the median amount of life insurance is more realistic. The median amount of life insurance for insured households was only $128,000, which would provide income to the surviving family members for a considerably shorter period. About 3 in 10 households (35 million) had no life insurance at all.8 Another study sponsored by New York Life shows that many Americans have only about half of the amount of life insurance needed to attain their own self-described financial goals. A survey of 1,003 Americans with dependents and household incomes of $50,000 or more revealed a serious problem of underinsurance. The median amount that respondents reported they needed from their life insurance proceeds to attain their financial goals was $589,378, but the median amount of actual life insurance protection was only $300,000, a gap of 49 percent.9 Based on the above findings, it is clear that the life insurance industry must do a better job educating families about the need for life insurance, the affordability of life insurance, and the correct amount of life insurance to own. Reduction in Income

Many families experience a substantial reduction in income and standard of living after a family head dies. This is especially true for many older surviving spouses who are not in the labor force at the time the family head dies, and the amount of life insurance proceeds, if any, is inadequate. To receive OASDI survivor benefits, a surviving spouse must be age 60 or older, or be age 50 or older and disabled, or be caring for

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eligible children under age 16. Because of women’s longer life expectancy, most older surviving spouses are widows. Widows under age 60 are generally ineligible for monthly survivor OASDI benefits because they are not disabled, or their children are grown. As a result, older widows under age 60 who are not in the labor force at the time the family head dies can experience severe economic insecurity since their major source of income is cut off. In summary, after the family head dies, two important problems clearly stand out: loneliness and grief, and insufficient income for many families. It is clear that premature death can cause considerable economic insecurity.

Reducing Economic Insecurity from Premature Death Numerous techniques are available to reduce economic insecurity from premature death. Some measures are more appropriate before the family head actually dies, while other approaches become operational after death occurs.

Impact Before Death Occurs Some important measures for meeting the problem of premature death before death occurs include the following: • Lifestyle changes • Hospice care • Support groups • Accelerated death benefits rider • Living will Lifestyle Changes

Lifestyle changes can prevent many diseases and reduce early death. In the United States, people often die early because of diseases caused by smoking, alcohol abuse, use of illegal drugs, high blood pressure, high blood cholesterol, obesity, and physical inactivity and lack of exercise. Because of the Internet and greater public awareness, Americans are bombarded with information on the importance of physical fitness and aerobic exercise, weight control, low-fat diets, cessation of smoking, moderation in drinking, stress management, hypertension control, and cholesterol testing. Lifestyle changes can be especially effective in reducing premature death from heart attacks, cancer, diabetes, and strokes, which are leading causes of death in the United States. Hospice Care

Hospice programs are aimed primarily at assisting terminally ill patients and their families. Hospice care provides medical relief of pain and supportive services to terminally ill persons as well as assistance to families in adjusting to the patient’s

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illness and death.10 The basic objective is to make the dying patient as comfortable as possible and to help the family cope with the stress. Hospice programs typically have the following characteristics: • The patient and family are considered the unit of care, not just the patient. • An interdisciplinary team provides physical, psychological, and spiritual assistance to the patient and family and provides for an overall coordinated plan of care. • Physical pain is controlled with appropriate palliative medication, but no heroic efforts are made to cure the patient. • Bereavement services are available to help family members deal with the emotional suffering associated with the patient’s death. As an approach to meeting the problem of premature death, hospice care has several advantages. First, physical pain is controlled, especially for cancer patients. Second, terminally ill patients are given emotional support and assistance in accepting their illness and imminent death. This assistance is especially helpful to dying patients who are still denying the seriousness of their illness. Third, supportive services are provided to the patient’s family both before and after death to reduce the emotional pain, suffering, and grief. Finally, hospice care has the potential for lowering the cost of dying and medical care provided to the terminally ill. The programs are designed so that the patient can die at home, or care is provided in lower-cost facilities, such as an inpatient hospice facility, rather than in a more expensive hospital or nursing home. Hospices are heavily staffed with volunteer workers, which also reduces the cost of dying. Support Groups

Support groups are another approach to premature death. A terminally ill person periodically meets with other people who are terminally ill or are experiencing serious health problems, and common problems are discussed. The intent is to share mutual experiences, strength, and hope with each other so that facing death is easier. For example, many hospitals have support groups for terminally ill cancer patients who meet periodically to discuss common problems. Many communities also have grief programs for surviving spouses and family members who have recently experienced the death of a close family member. Surviving family members meet periodically to discuss issues and feelings associated with the death of a loved one, such as guilt, loneliness, resentment, anger, and depression. Grief programs enable surviving family members to adjust more quickly to the death of a loved one and work through the grieving process more easily. The stress and pain that accompany the death of a close family member can be dealt with more effectively by talking to others who have also experienced the death of a loved one. Accelerated Death Benefits Rider

An accelerated death benefits rider is another approach to premature death. Most life insurers make available a living benefits rider that can be added to a life in-

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surance policy. The accelerated death benefits rider allows insured individuals who are terminally ill or have certain catastrophic diseases to collect part of or the entire face amount of their life insurance proceeds prior to death. As a result, the terminally ill individual has a source of funds to pay medical bills and living expenses. There are several types of riders.11 A terminal illness rider permits the terminally ill insured with a life expectancy of one year or less to collect part or all of their life insurance proceeds. Any lump sum paid is discounted for interest to reflect the time value of money. A catastrophic illness rider permits the insured with certain catastrophic diseases to receive part or the entire policy face amount. Covered diseases commonly include AIDS, coronary artery disease, life-threatening cancer, kidney failure, and similar forms of catastrophic disease. Finally, a long-term care rider allows insured individuals who require long-term care to collect part of the policy face amount prior to death to help pay for the cost of care. The rider typically covers both skilled and intermediate care, as well as custodial care. To illustrate, a monthly benefit equal to 2 percent of the face amount of insurance could be paid up to a maximum of 50 percent of the face amount. Thus, if the insured has $100,000 of life insurance, a monthly benefit of $200,000 could be paid for up to 25 months. A viatical settlement is another approach for providing cash to terminally ill people with life insurance. A viatical settlement is the sale of a life insurance policy by a terminally ill insured individual to another party, typically to investors or investor groups who hope to profit by the insured’s early death. The cash enables the ill person to pay medical bills and living expenses. However, many states do not adequately regulate viatical settlements, and there is potential for abuse. Living Will

Terminally ill patients may be kept alive for extended periods by machines and other types of treatment, which could be contrary to their wishes. Federal law requires hospitals to obtain information from patients regarding end-of-life treatment. A living will is a document that states the type of medical care that should be provided if the patient becomes mentally or physically disabled and is unable to make a rational decision. Some physicians will provide extraordinary methods of care to keep a terminally ill patient alive, often at great expense to the family and with little or no benefit to the patient. For example, a terminally ill patient can often be kept alive for an extended period by machines and new technology, such as experimental surgery or drugs. However, a terminally ill patient who is unable to make a rational medical decision might prefer that only ordinary treatment be provided, such as food, water, and pain relief, and that extraordinary methods of care should not be given. The patient’s wishes can be specifically stated in a living will.

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Reducing Impact of Economic Insecurity After Death Occurs Numerous measures can reduce the economic insecurity resulting from the death of the family head. Sources of replacement income and financial assistance to the surviving family members include the following: • OASDI survivor benefits • Private life insurance • Qualified retirement plans or profit-sharing death benefits • Individual retirement accounts (IRAs) • Employment earnings • Savings and investment income • Relatives, friends, and charities • Public assistance and other miscellaneous sources of income OASDI Survivor Benefits

OASDI survivor benefits are extremely important in reducing economic insecurity from premature death. Along with employment earnings, they are an important source of income to surviving spouses with eligible children under age 16 in their care (or age 16 and over and disabled before age 22). Benefits can also be paid to unmarried children under age 18 (or under age 19 if a full-time elementary or high school student). The payments include monthly cash benefits and a nominal funeral benefit. The monthly benefits help to maintain the family’s standard of living and prevent financial hardship. The value of OASDI survivor benefits to an average family is substantial. For example, assume that a worker, age 30, has a spouse age 28, a child age 2, and an infant under one. In terms of private life insurance equivalents, the value of the survivor benefits is $433,000.12 The benefits, however, are paid monthly and not in a lump sum. Although the OASDI program provides an important layer of income protection, the economic position of many surviving spouses is still precarious, especially for older widows. As stated earlier, not all surviving widows receive monthly survivor benefits. Many widows are ineligible for monthly cash benefits because they are under age 60 and have no eligible children in their care. Also, some widows are working and have earnings in excess of the annual limit under the earnings test, which results in a reduction or termination of monthly benefits. Finally, some younger widows may remarry, thereby losing their benefits. The problem of an older widow under age 60 with no eligible children in her care is especially difficult. Many older widows under age 60 with grown children do not have a current attachment to the labor force at the time of a spouse’s death. Older women under age 60 often withdraw from the labor force years before their husbands die. Since OASDI monthly survivor benefits may not be available, and other sources of income could be inadequate, older widows may be forced to find a job. However,

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employment opportunities may be limited because of high unemployment in the community, inadequate or obsolete work skills, or an ineffective job search. Older widows in this category with limited employment opportunities may find it extremely difficult to attain meaningful economic security. Private Life Insurance

Both individual insurance and group life insurance are excellent techniques for reducing economic insecurity from premature death. Private individual life insurance, however, is not being used to the maximum extent possible. Most family heads die underinsured, with only a small fraction of their human life values insured. Many family heads fail to recognize that as their family needs change over time, the amount of life insurance coverage should also change. The amount of life insurance carried may be inadequate because of inflation that significantly reduces the real purchasing power of the death proceeds, an upgrading of aspirations that require more income, and improvements in the nation’s standard of living. Failure to upgrade the amount of life insurance is widespread today among the older insured, who purchased their life insurance at younger ages. Although individual life insurance can significantly reduce economic insecurity from premature death, certain limitations must be recognized. Life insurance may not be available if the family head is uninsurable; lower-income groups most in need of protection lack the ability to pay for large amounts of insurance; and applicants for insurance may receive poor advice from some agents concerning the type of insurance to purchase. In particular, younger family heads with children need substantial amounts of life insurance, but the amount of income available for the purchase of life insurance is often limited. Instead of advising applicants to purchase inexpensive term insurance, some agents attempt to sell more expensive types of life insurance, such as ordinary life insurance or universal life insurance, which provide higher commissions for the agent. As a result, many younger families with limited incomes are substantially underinsured. In addition, many family heads have inadequate knowledge of the different types of life insurance and believe they have no need for additional coverage. Finally, agents often give inadequate advice to their clients with respect to the use of settlement options, life insurance planning, and the disposition and investment of policy proceeds. Group life insurance benefits may also be available. Many employers provide some group life insurance benefits to their workers. Group insurance has the advantages of low-cost protection, mass coverage, and the availability of insurance even if the worker is substandard or uninsurable. The coverage is typically available without evidence of insurability if the employee applies before or during his or her eligibility period. Qualified Retirement Plan or Profit-Sharing Death Benefits

Death benefits may also be available to surviving dependents under a qualified retirement plan or profit-sharing plan. Qualified retirement plans are employer-sponsored

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retirement plans with favorable income-tax treatment. In a qualified plan that meets Internal Revenue Service (IRS) requirements, the employer’s contributions are income-tax deductible up to certain limits and are not currently taxable as income to participating employees. The employee’s contributions generally are made with before-tax dollars. Most employer-sponsored retirement plans today are defined-contribution plans in which the employee-and-employer contribution rate is specified, but the actual retirement amount varies for each worker, depending on age of entry into the plan, investment returns, and retirement age. For example, the employee and employer may each contribute 6 percent of salary into a 401(k) retirement plan. The plan may specify age 65 as the normal retirement age and age 55 as the early retirement age. The employer’s plan may be a profit-sharing plan in which eligible employees share in the profits of the firm. The amount contributed to a participant’s account is based on a formula that may include the worker’s salary, years of employment, and other factors. In a 401(k) plan, if a worker dies before retirement, the accumulated value of his or her contributions is typically paid to a surviving spouse as a death benefit; part or all of the employer’s contributions is also paid if the deceased worker has vested benefits. If the worker dies after retirement, the remaining balance in the account is typically paid to the surviving spouse as beneficiary. Likewise, in a profit-sharing plan, the value of the account is paid as a death benefit to a surviving spouse or other specified beneficiary. Individual Retirement Accounts (IRAs)

Individual retirement accounts (IRAs) are another source of income to surviving family members. Many workers in the United States establish individual retirement accounts (IRAs) to supplement their OASDI benefits. There are two basic types of IRA plans. A traditional IRA allows workers to make contributions to a retirement plan up to certain annual limits; the contributions are income-tax deductible; the investment income accumulates income-tax free on a tax-deferred basis; and the distributions are taxed as ordinary income. A Roth IRA is another type of IRA that has substantial tax advantages. The annual contributions to a Roth IRA are not income-tax deductible; the investment income, however, accumulates income-tax free; and qualified distributions are not taxable if certain requirements are met. Younger workers generally are better off financially by establishing a Roth IRA because qualified retirement distributions are not taxable. When an IRA account holder dies, the balance in the IRA account is paid or made available to a specified beneficiary, which typically is the surviving spouse or children. As a result, a source of income is available to supplement any OASDI survivor benefits, 401(k) benefits, profit-sharing benefits, or death benefits from other employer-sponsored retirement plans, such as a defined-benefit plan and definedcontribution plan.

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Employment Earnings

Employment earnings are also important in reducing economic insecurity from premature death. The majority of spouses with children are already in the labor force prior to the death of their husband or wife; others may reenter the labor force after a spouse dies. A surviving spouse who is working or reenters the labor force is more likely to maintain or improve his or her previous standard of living. In some cases, the surviving spouse has no choice but to work if OASDI survivor benefits and death benefits from life insurance and other sources are inadequate for meeting the family’s needs. Also, working has the additional advantage of helping the spouse overcome his or her loneliness and grief. A surviving spouse, however, faces two major obstacles if she or he wishes to reenter the labor force after the death of the other spouse. First, there may be preschool children who require someone to care for them. If the parent attempts to work by placing the children in a day-care center or by hiring a babysitter, substantial additional expenses are incurred, which reduce the disposable income available to the family. Second, if a surviving spouse has earned income that exceeds the limit allowed by the OASDI earnings test, he or she will lose part or all of the monthly survivor benefits. As a result, the incentive to work may be reduced. The OASDI earnings test is discussed in greater detail in Chapter 5. Investment Income

Investment income can also supplement the family’s income after the death of a family head. However, most married couples do not accumulate sizable financial assets prior to the death of a husband or wife, especially if death occurs at an early age. Thus, investment income generally accounts for only a small fraction of total income received by the family. Relatives and Friends

Relatives and friends can help meet the problem of premature death. Gifts of money can be given. This type of financial assistance, however, is temporary and is generally ineffective as a long-run solution to economic insecurity due to premature death. Most families need adequate and continuing income to attain meaningful economic security, and few friends or relatives are able to provide continuous financial assistance to a bereaved family. Any financial gifts are likely to be small and relatively insignificant. Private Charities

Private charities—churches, labor unions, fraternal organizations, and charitable organizations such as the Salvation Army and St. Vincent de Paul Society—may provide temporary financial assistance to surviving spouses with children. However, their effectiveness in reducing economic insecurity from premature death is constrained,

Summary  59

for, as in the case of relatives and friends, the amount of aid that private charities can provide is limited. Few charities or churches are able to provide continuous income payments to a large number of surviving spouses. In addition, some surviving spouses with children who need financial help find it distasteful to appeal to private charities for assistance. Most spouses do not consider charity an acceptable solution to their need for continuous and adequate income. Public Assistance

Public assistance benefits may be available to some surviving spouses and their children; however, these benefits are relatively unimportant in meeting the problem of premature death. Increased dependence on public assistance is not an effective solution to the problem of premature death. A stringent means test and strict eligibility and categorical requirements disqualify many spouses who apply for assistance. Also, some surviving spouses may be reluctant to apply for public assistance because of the stigma attached to the benefits. Finally, if assistance is obtained, the income generally is insufficient for meeting the full needs of the family, and unfulfilled needs make it difficult to attain economic security because a reasonable standard of living is not being attained. Other Sources of Income

The family may also be eligible to receive death benefits from other public programs, including veterans’ benefits; death benefits from the Federal Employees Retirement System, Civil Service Retirement System, or Railroad Retirement System; and workers’ compensation if the death is job related. A surviving spouse may also receive funds from the sale of the deceased’s business interest, or from the sale of household possessions.

Summary • Premature death can be defined as death of a family head with unfulfilled financial obligations, such as dependents to support, children to educate, a mortgage to be paid off, and other installment debts. • Society incurs certain costs because of premature death. The family’s share of the deceased’s future income is lost forever; additional expenses may be incurred; the family may be uncertain regarding the continuation of future income; because of insufficient income, many families experience a reduced standard of living; and certain noneconomic costs are incurred, such as the emotional grief of a surviving spouse. • Premature death can cause considerable economic insecurity in cases such as death of a single-parent family head, of a parent in a two-income-earner family with children, or in a traditional, sandwiched, or blended family. In contrast, if a single person without dependents or an income earner in a two-income family without children dies, financial problems for the survivors are less likely to ­occur.

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• Before a terminally ill family head dies, there may be a disruption of normal living patterns, a decline in the family’s income, reduced employment opportunities for the family head, catastrophic medical expenses, and the loss or reduction of employee benefits. Many spouses are inadequately prepared for a premature death. • After death occurs, the surviving spouse often faces problems of loneliness and grief, payment of final medical and funeral expenses, inadequate life insurance proceeds, and a reduction in the family’s income. • Important approaches for reducing the problem of premature death before the death occurs are lifestyle changes, hospice care, support groups, accelerated death benefits riders, and a living will. • After a family head dies, the surviving family may receive replacement income from a number of sources, including OASDI survivor benefits; death benefits from an employer-sponsored 401(k) plan, profit-sharing plan, or qualified employer retirement plan; proceeds from an individual retirement account (IRA); employment earnings; and savings and investments. The family may also receive public assistance and limited help from friends and relatives and charitable organizations.

Review Questions 1. Give the definition of premature death. 2. Briefly describe the costs associated with premature death. 3. Does premature death affect all types of families the same way? Explain your answer. 4. Briefly explain the financial impact of premature death on the family before a terminally ill family head actually dies. 5. Briefly explain the financial impact of premature death on the family after a terminally ill family head dies. 6. Identify the various measures that can reduce economic security from premature death. 7. Are OASDI survivor benefits paid to all surviving spouses? Explain your answer. 8. How effective is private life insurance in meeting the problem of premature death? 9. Describe the major sources of income to surviving spouses with children after a terminally ill family head dies. 10. Explain the major obstacles that an older surviving spouse whose children are grown may encounter when she or he wishes to reenter the labor force after the death of the other spouse.

Application Questions 1. Megan, age 35, is an actuary for a small fraternal life insurer. She is married with two small children, and plans to retire at age 65. She estimates that her

Internet Resources  61

average annual earnings over the next 30 years will be $60,000. She also estimates that one-half of her earnings will be used for federal and state taxes, life and health insurance premiums, 401(k) contributions, and her personal needs. Based on a discount rate of 5 percent, the present value of 30 annual payments of $1 at the end of each year is $15.37. Calculate Megan’s human life value. 2. The financial impact of premature death varies by family type. For each of the following, explain the financial impact of premature death on surviving family members. Treat each event separately. a. Kelly, age 35, is a single parent with two small children, ages 3 and 5. She earns $25,000 annually as a waitress in a local restaurant. She has $10,000 of life insurance, which her parents purchased for her when she was a child. On her way home from work, Kelly is killed by a motorist who failed to stop at a red light. The restaurant does not provide health insurance or retirement benefits to its employees. b. David, age 48, is married with two preschool-age children. He is an auto mechanic who is employed at a small auto repair firm and earns $30,000 annually. His spouse is not in the labor force but remains at home to care for the children. David is diagnosed with cancer of the pancreas and is forced to withdraw from the labor force. He dies nine months later. At the time of his death, medical bills total $150,000. David has no health insurance because his employer was forced to drop its group health insurance plan due to a substantial increase in premiums. He has only $30,000 of group life insurance provided by his employer. c. Susan, age 47, is a nurse at a local hospital and earns $50,000 annually. She is married to Brandon, age 48, who is employed by a telephone company and earns $35,000 annually. The company provides $35,000 of group life insurance on his life. The couple has two children. Jeremy, age 20, is a sophomore at a state university, and both parents help pay for his tuition. Alex, age 18, is a senior in high school and plans to attend college. Five days before Alex is scheduled to graduate from high school, Brandon is killed unexpectedly after his motorcycle hits a pothole in the road and he is thrown off the motorcycle and struck by an oncoming vehicle. Brandon participated in the company’s 401(k) plan with an account balance of $25,000 at the time of his death.

Internet Resources • The American Council of Life Insurers represents the life insurance industry on issues dealing with legislation at the federal and state levels. The site provides consumer information on the uses and types of life insurance. Visit the site at www.acli.com • The Consumer Federation of America is a nonprofit organization that represents consumer groups. This site is one of the best sources for obtaining meaningful information about life insurance and other insurance products. Visit the site at http://consumerfed.org

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• The Office of Chief Actuary in the Social Security Administration provides actuarial cost estimates of the OASDI program and determines the annual costof-living adjustments in benefits. The site provides a number of timely publications. Visit the site at www.socialsecurity.gov/OACT • Social Security Online is the official Web site for the Social Security Administration, which administers the Social Security (OASDI) program in the United States. The site provides significant and detailed information on Social Security survivor benefits, eligibility requirements for surviving family members, benefits for surviving children, and detailed information on how to apply for benefits. Visit the site at www.ssa.gov • The Social Security Advisory Board advises the president and Congress on issues relating to the Social Security program in the United States. The site provides timely and relevant reports dealing with Social Security. Visit the site at www.ssab.gov • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on Social Security and Medicare on its Web site. Visit the site at www.nasi.org

Selected References American Council of Life Insurers. 2010 Life Insurers Fact Book. Washington, DC: American Council of Life Insurers, 2010. Myers, Robert J. Social Security. 4th ed. Philadelphia: Pension Research Council and University of Pennsylvania Press, 1993. National Academy of Social Insurance. Social Security: An Essential Asset and Insurance Protection for All. Social Security Brief no. 26, February 2008. ———. “The Role of Benefits in Income and Poverty.” This site periodically updates and highlights key facts about Social Security. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office, 2011. U.S. Census Bureau. Income, Poverty, and Health Insurance Coverage in the United States: 2010. Washington, DC, September 2011. ———. Statistical Abstract of the United States: 2012 (131st ed.) Washington, DC, 2011. Williams, C. Arthur, Jr., John G. Turnbull, and Earl F. Cheit. Economic and Social Security. 5th ed. New York: John Wiley & Sons, 1982. Chapter 2.

Notes 1. U.S. Census Bureau, Statistical Abstract of the United States: 2011. 130th ed. (Washington, DC, 2010), Table 120. 2. Ibid. 3. Centers for Disease Control, National Center for Health Statistics, “U.S. Death Rate Falls for the 10th Straight Year.” Press release, March 16, 2011. 4. U.S. Census Bureau, Statistical Abstract of the United States: 2012, 131st ed. (Washington, DC, 2011), Table 1340. 5. Centers for Disease Control and Prevention, “Obesity: Halting the Epidemic by Making Health Easier, At a Glance.” Atlanta, Georgia, 2011.

Notes  63 6. Marian F. MacDorman, and T.J. Mathews, “Behind International Rankings of Infant Mortality: How the United States Compares with Europe.” NCHS Data Brief, No. 23, November 2009, National Center for Health Statistics, Atlanta, Georgia. 7. U.S. Census Bureau, Housing and Household Economics Statistics Division, Historical Poverty Tables—Current Population Survey, September 2009, Families, Table 4. 8. Cheryl D. Retzloff, LIMRA, Household Trends in U.S. Life Insurance Ownership, LL Global, Inc., 2010. 9. New York Life, “Coming Up Short: New Study Reveals Wide Chasm Between Life Insurance Coverage and Common Financial Goals for Millions of Americans.” Press release, December 2, 2008. 10. General Accounting Office, “Hospice Care—A Growing Concept in the United States.” Report to the Congress of the United States (Washington, DC: U.S. Government Printing Office, 1979), p. 1. 11. George E. Rejda, Principles of Risk Management and Insurance. 11th ed. (Boston: Pearson Education, 2011), p. 261. 12. National Academy of Social Insurance, “Social Security Is Worth $225,000 for a Typical Retiree.” Press release, January 31, 2008.

4 Problem of Old Age

Student Learning Objectives After studying this chapter, you should be able to: • Identify the major factors that cause economic insecurity for retired people. • Explain the impact of early retirement on the financial position of the aged. • Identify the major sources of income to retired workers. • Explain the reasons why many elderly have insufficient financial assets at ­retirement. • Explain the employment problems of older workers. • Identify the major techniques for reducing economic insecurity from old age. • Explain the importance of Old-Age, Survivors, and Disability Insurance (OASDI) retirement benefits in providing economic security to retired workers. Most workers dream of financial independence, additional leisure, and a comfortable retirement. The goal of early retirement is especially strong. Some workers retire early because they dislike their jobs, wish to travel, or start a second career. Some older workers have no choice but are forced into early retirement because of outsourcing of jobs to foreign countries, technological change and plant shutdowns, economic recession and high unemployment, or poor health. As a result, retired workers generally spend a relatively longer period of their adult lives in retirement, and for many of them, the incomes they receive are insufficient for maintaining a reasonable standard of living. In addition, most workers seriously underestimate the amount of money needed for a comfortable retirement; as a result, they do not save enough during their working years and may experience a reduced standard of living after retirement. Also, millions of retired Americans live in poverty, and the problem of poverty among aged widows is particularly acute. Other retired workers are in poor health and require expensive long-term care in a nursing facility. Some retired workers must deal with the problems of high property taxes, inadequate low-cost housing, inadequate transportation, exploitation, and physical and psychological 64

Nature

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Old-Age Problem  65

abuse. Finally, many older workers experience difficulty finding jobs because of arbitrary age discrimination. In this chapter, we discuss each of the above problems of old age in some detail. We conclude the chapter with a discussion of the various techniques for reducing economic insecurity among the elderly.

Nature of the Old-Age Problem The economic problem of old age consists of the following: • Growing proportion of older people in the population • Loss of earned income because of retirement • Longer retirement period • Insufficient income and assets • Poverty among the aged • Poor health • Long-term care costs • High property taxes • Inflation • Other financial problems • Abuse of the elderly

Growing Proportion of Older People in the Population Because of an increase in life expectancy, the proportion of older people in the population has increased dramatically over time and will explode in the future. In 2010, the aged 65-and-older group totaled 40.3 million, or 13 percent of the population. In 2050, based on intermediate population estimates, Social Security actuaries estimate that the elderly population will more than double, to 83.6 million, or 20.4 percent of the population.1 As the proportion of aged in the population increases, the burden on society will increase sharply as a smaller proportion of workers must support a larger proportion of older people. Moreover, unless these older retirees receive adequate retirement income from Social Security benefits, individual retirement accounts (IRAs), 401(k) plans, private pension plans, accumulated savings, or other sources, they will be exposed to serious economic insecurity.

Loss of Earned Income Because of Retirement Loss of earned income because of retirement is an important cause of economic insecurity. As stated earlier, unless replacement income from all sources is adequate for maintaining a reasonable standard of living, retired workers will be exposed to considerable economic insecurity during retirement. In the past, mandatory retirement has been a significant cause of economic insecurity for some older workers due to loss of earned income. Employers defended a mandatory retirement age, such as age 65, on the grounds that older workers could

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retire in a dignified fashion; a uniform retirement policy could be applied to all workers; employers were relieved of the problem of permitting certain older workers to continue working while asking others to retire; and employment and promotion opportunities were increased for younger workers. Mandatory retirement today, however, is less important as a cause of economic insecurity in old age. As a result of the Age Discrimination in Employment Act, the vast majority of employees in private firms and state and local government cannot be forced to retire at any retirement age. With certain exceptions, it is now illegal for employers to require workers to retire at some stated retirement age, such as age 65. As a practical matter, however, most employees retire long before age 65. In 2009, the labor force partipation rate for males and females, age 65 and over, was only about 22 percent for males and 13.6 percent for females, respectively.2

Longer Retirement Period A longer retirement period is another part of the economic problem of old age. Most retired workers today are spending a longer period of their adult lifetimes in retirement and a shorter period in productive employment. Because of a shorter period of work earnings, many workers do not save enough during their working years to maintain a reasonable standard of living during the longer retirement period. The relatively longer retirement period and shorter working period can be explained by (1) an increase in life expectancy at the older ages, (2) early retirement, and (3) a longer period of formal education. Increase in Life Expectancy at the Older Ages

The longer retirement period is partly due to an increase in life expectancy at the older ages. Although most of the increase in life expectancy over time has occurred at the younger ages, there has been an increase at the older ages as well. Life expectancy of a male age 65 increased from 13.1 years in 1970 to an estimated 17.5 years in 2010; for females, life expectancy increased from 17.1 years in 1970 to an estimated 19.9 years in 2010.3 As will be discussed later, many retired workers have limited amounts of savings. The increase in life expectancy and longer retirement period increase the risk that some retirees will exhaust or substantially reduce their savings before they die, which will only aggravate any economic insecurity that the retiree may be experiencing at that time. Early Retirement

The majority of workers retire before the full retirement age, which reduces the period of productive earnings and increases the duration of retirement. In 2009, the labor force participation rate for males ages 55–64 was only 70 percent; for females in the same age group, the labor force participation rate was only 60 percent.4 A shorter period of work reduces the amounts workers can accumulate in individual retirement

Nature

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Old-Age Problem  67

accounts, 401(k) plans, profit-sharing plans, or other defined-contribution retirement plans. As a result, early retirement reduces the amount of savings that workers can accumulate for retirement. In addition, some retired workers receive benefits from defined-benefit pension plans. Although defined-benefit pension plans have declined in relative importance, these plans pay retirement benefits to millions of retired workers at the present time. Defined-benefit pension plans are plans that pay guaranteed benefits to retired workers; the retirement benefit is known in advance, but employer contributions into the plan vary depending on the amount needed to fund the desired benefits. The formula for calculating the benefit amounts is typically based on the worker’s earnings and years of service. Years of service are extremely important in determining the final benefit amount. When workers retire early, the benefits are actuarially reduced because of fewer years of contributions and a longer duration of retirement. As a result, many early retirees have insufficient incomes during retirement. In addition, few defined-benefit pension plans are automatically adjusted for inflation each year. As a result, inflation can gradually erode the real incomes of workers who have retired early, which also aggravates the problem of insufficient income. Reasons for Early Retirement

Workers retire early for a variety of reasons. Some retire because of the desire for additional leisure and time to travel; others are dissatisfied with their jobs, or want to pursue a second career; still others retire because of poor health. The availability of early retirement benefits under Social Security and employersponsored retirement plans encourages many older workers to retire early; workers who can look forward to substantial private pension benefits are more likely to do so. Many workers are forced to retire because of circumstances beyond their control. During the financial meltdown and severe recession that occurred in the United States in 2008 and 2009, many older workers were forced into retirement because they could not find jobs. Others retire because of the widespread outsourcing of jobs by corporations to foreign nations, technological change that eliminates jobs, company mergers and changes in demand that result in layoffs and plant closings, and labor union and management pressures. In addition, the total family income of married working couples initially may not be significantly reduced by early retirement, which encourages some workers to retire early. There has been an increase in two-income families in which one spouse remains employed while the other spouse retires. The loss of earned income can be partially offset by Social Security benefits as early as age 62, and by benefits from 401(k) plans, individual retirement accounts, profit-sharing plans, and other qualified retirement plans. Finally, to reduce labor costs, many corporations have permanently reduced the size of their labor force. To encourage older workers to retire, employers typically design attractive severance packages, which may include several months of salary, health

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insurance paid by the employer for a limited period, or a smaller actuarial reduction in early retirement benefits in defined-benefit pension plans. This practice is called a “buyout” by which older workers with long periods of service have a financial incentive to retire early. Impact of Early Retirement

Early retirement can aggravate economic insecurity during the retirement period. First, it generally reduces the amount of accumulated savings because the period of productive work is shortened. Thus, the income that such savings can provide during retirement will be lower than if the worker had worked to the normal retirement age. Second, if workers retire early, public or private pensions in defined-benefit pension plans generally are actuarially or otherwise reduced. As a result, early retirement benefits alone may be inadequate for maintaining a reasonable standard of living during a longer retirement period. Third, some workers who retire early lose their employer-financed group health insurance. Many firms have discontinued or reduced group health insurance benefits for workers who have retired early. Other firms have increased the retired worker’s share of premiums. The financial impact on the early retiree’s budget can be substantial. Finally, some retired workers under age 65 who lose their group health insurance are uninsurable. Others go uninsured or are forced to pay relatively high premiums for individual coverage. In addition, eligibility for coverage under Medicare does not start until age 65. As a result, many workers who retire early may be faced with substantial additional expenses if individual health insurance has to be purchased. However, the problem of economic insecurity from early retirement may be declining. Older workers are now staying in the labor force for longer periods. A recent study by the Employee Benefit Research Institute showed that the percentage of older workers in the labor force continues to increase. The percentage of workers age 55 or older who work full time steadily increased from 54.2 percent in 1993 to 66 percent in 2007, before a decline to 63.9 percent in 2008.5 Older workers often delay retiring for a number of reasons. Many older workers have postponed retirement to recoup the substantial stock market losses they incurred in their 401(k) plans and other retirement plans during the severe financial meltdown and economic downswing in 2008 and 2009; others delay retiring because they need affordable employer-sponsored health insurance; still others experience a change in their employment situation and cannot afford to retire. Longer Period of Formal Education

A longer period of formal education over time is a final reason for the increase in the duration of retirement. A highly industrialized economy requires a skilled labor force, which necessitates a longer period of formal education. A longer period of formal education delays entry into the labor force, thereby reducing the period of productive earnings. The need for a more highly educated labor force, legal restrictions on

Nature

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Old-Age Problem  69

child labor, compulsory education, and increased emphasis on a college education have increased the average age of entry into the labor force. The higher entry age reduces the period of employment and increases the period of retirement. Thus, in a highly industrialized economy, the average worker spends a relatively shorter period preparing economically for a relatively longer retirement period.

Insufficient Income and Assets Many retired persons experience considerable economic insecurity because of insufficient income. Total income may be insufficient for attaining a reasonable standard of living. In addition, many older people have limited savings and insufficient financial assets. Size of Income

It is a mistake to assume that all retired persons are financially wealthy; it is equally wrong to assume that the aged as a group are poor. The aged are an economically diverse group, and their incomes are far from uniform. Figure 4.1 shows the total income received by aged units 65 or older in 2008. Median income for aged units was only $24,857 in 2008.6 However, there is substantial variation in the amount of income received. In 2008, about 13 percent of the aged units had total money incomes under $10,000. At the other extreme, roughly 23 percent had incomes of $50,000 or more. Thus, a small proportion of aged units were exposed to substantial economic insecurity, and at the same time, a much higher proportion of the elderly were able to attain a reasonable standard of living. Sources of Income

It is also important to analyze the various sources of income received by the aged to determine their relative importance. Figure 4.2 shows that aggregate income of the aged in 2008 came primarily from four major sources: (1) Social Security, (2) work earnings, (3) public and private pensions, and (4) asset income, such as interest and dividends. These four sources accounted for 97 percent of the aggregate income received in 2008. The figure reveals that Social Security provides the largest share of aggregate income for people age 65 and older. Public assistance and other sources of income were relatively insignificant. Social Security benefits are especially important in providing economic security to the elderly. In 2008, nearly 9 out of 10 aged units received Social Security benefits. Social Security provided at least half of the total income for the majority of beneficiary aged units in 2008.7 Without Social Security, the majority of the aged units would have been exposed to great economic insecurity. Financial Assets of the Aged

An accurate analysis of the financial situation of the aged must also consider the total financial assets that they own. Although earned income may terminate or be reduced at

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Figure 4.1  The Aged are an Economically Diverse Group The median income for units aged 65 or older is $24,857, but there are wide differences within the total group. Approximately 13 percent have an income of under $10,000, and roughly 23 percent have an income of $50,000 or more.

Percentage with various levels of income, 2008 

Percent



15.4

11.7



10.0

10.2



8.6 7.9

7.7 6.1



5.4

5.3 4.6

4.1 3.0

 less than 5,000

5,000 to 10,000 9,999 to 14,999

15,000 to 19,999

20,000 to 24,999

25,000 to 29,999

30,000 to 34,999

35,000 to 39,999

40,000 to 44,999

45,000 to 49,999

50,000 to 74,999

75,000 100,000 or more to 99,999

Income (dollars)

Note: Totals do not necessarily equal the sum of the rounded components. Source: Social Security Administration, Income of the Aged Chartbook, 2008, April 2010.

retirement, income from dividends, interest, and other financial assets can partially or completely offset the loss of earned income. Financial assets also provide a cushion for contingencies that may arise during the retirement period, such as unexpected medical bills that are not covered or are excluded by Medicare and private health insurance contracts, or paying for the cost of long-term care in a skilled nursing facility. Previous research studies show clearly that a large proportion of older retired people have not saved enough for a comfortable retirement. A 2010 survey by the Employee Benefit Research Institute (EBRI) also shows that most retirees have not saved enough for a comfortable retirement. The survey found that 56 percent of the retirees who responded to the survey reported total savings and investments of less than $25,000, which did not include the value of their primary residence or defined-benefit pension plans.8 This amount is inadequate for a comfortable retirement. The EBRI survey also revealed wide variation in total savings and investments

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Figure 4.2  Social Security Provides the Largest Share of Aggregate Income for Units Aged 65 or Older Aggregate income for the aged population comes largely from four sources. Social Security accounts for 36.5 percent, earnings for 29.7 percent, pensions for 18.5 percent, and asset income for 12.7 percent. Only 2.7 percent comes from other sources.

Shares of aggregate income, by source, 2008 Pensions 18%

Asset income 13% Other 3%

Earnings 30%

Social Security 36%

Note: Totals do not necessarily equal the sum of the rounded components. Source: Social Security Administration, Income of the Aged Chartbook, 2008, April 2010.

reported by retirees. At one extreme, 27 percent of the retirees who responded reported total savings and investments of less than $1,000. At the other extreme, only 12 percent of the respondents reported total savings and investments of $250,000 or more.9 The first group obviously is exposed to serious economic insecurity if an event occurs that requires a large outlay of money, while the second group owned financial assets that provided greater protection against financial insecurity. A number of reasons help explain the relatively poor financial asset position of many older people: • Some workers save little or nothing for retirement because their work earnings are simply too low to accumulate substantial savings. This is particularly true for family heads who earn only the federal minimum wage ($7.25 per hour in 2011), or for low-income workers with earnings slightly above the federal minimum wage. • Some workers have little or no savings at retirement because of repeated spells of unemployment, uninsured catastrophic medical bills, or some other financial emergency that exhausts their savings.

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• Many workers, however, do not consider saving for retirement to be a high priority; other workers procrastinate and never get around to setting up a savings plan. • Some workers elect not to participate in employer-sponsored retirement plans that encourage savings and provide favorable income-tax advantages, such as 401(k) or defined-contribution retirement plans. Although financially able to do so, many participants contribute less than the full amount that the plan permits. • Many workers underestimate the amount needed for a comfortable retirement; still others lack knowledge about financial planning and saving for retirement. • Millions of workers place a high priority on current consumption, incur substantial credit-card debts that are repaid monthly at high interest rates; or purchase cars or homes that are too expensive to afford with high monthly payments that make a deep dent in disposable income. Many Americans resist cutting back to save for retirement.

Poverty Among the Aged Many retired people live in poverty and are economically insecure. Based on the official poverty measure, 46.6 million, or 15.1 percent of the population were counted poor in 2010. The poverty rate for the aged was significantly lower (9 percent). However, the official poverty measure does not consider food stamps, payroll taxes, earned income tax credit, rising standards of living, expenses related to work, child care expenses, medical costs, and geographical price differences. To account for these factors, the Census Bureau has developed a more comprehensive supplemental poverty measure, which shows that the poverty rate for the aged is significantly higher than is commonly believed. The new measure shows that the poverty rate for the aged 65 and older was 15.9 percent in 2010, or about 68 percent higher than the official rate released earlier.10 When poverty among the aged is analyzed, a serious problem exists for a large proportion of older spouses who are widows. Most retired married couples are not poor. This is not true, however, for older unmarried women who live alone. According to one study by the National Academy of Social Insurance, 45 percent of the U.S. women living alone after age 65 are poor.11 Elderly widows are an important part of this group. Why is the poverty rate for older unmarried women so high? A study by the General Accounting Office concluded that the high poverty rate for unmarried women age 65 and over can be partly explained by widowhood. Older widows are more likely to be poor than older married couples. For example, consider the case of a married couple both over age 65. When one spouse dies, the Social Security benefits paid to the surviving spouse are reduced to the level of a single retired person. Such a reduction can place the surviving spouse in poverty, especially if the family’s income before the death occurred was only slightly above the poverty line. The death of one spouse would reduce the benefits, which causes the surviving spouse to fall into poverty.

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Since women have higher life expectancies than men, they are more likely to become widows and, as a result, more likely to fall into poverty. Older women may also be receiving retirement benefits from a husband’s private pension plan. When the husband dies, the retirement benefit to the widow might be reduced or even terminated, making the widow more vulnerable to poverty. Summary

Based on the preceding analysis, the financial position of the aged is summarized as follows: • The aged as a group are an economically diverse group, neither wealthy nor poor. In 2008, about 13 percent of aged units had incomes under $10,000, while 23 percent received $50,0000 or more. • The major sources of income to the aged in 2008 came primarily from Social Security, work earnings, public and private pensions, and asset income, such as interest and dividends. These four sources accounted for 97 percent of the total incomes received by the aged in 2008. • Studies show that the aged as a group have limited financial assets. Workers generally are not saving enough for a comfortable retirement. The EBRI study showed that 27 percent of the retirees reported total savings and investments of less than $1,000. At the other extreme, only 12 percent of the respondents reported total savings and investments of $250,000 or more • The poverty rate is also substantially higher for elderly widows.

Poor Health Another important facet of the problem of old age is that the elderly as a group are in poorer health than the general population. People age 65 and older see physicians more often, are more likely to become disabled, and have longer hospital stays. Although Medicare covers virtually all individuals aged 65 and older, the aged still must spend a relatively large proportion of their money income on health care. Health problems of older people can be divided into two major categories: (1) chronic conditions and (2) long-term care. Chronic Conditions

Older people generally have one or more chronic conditions that require continuous medical treatment. Some common examples are arthritis, hearing impairments, heart disease, diabetes, cataracts, high blood pressure, back problems, and hip and knee replacements. Although virtually all people age 65 and older are covered by Medicare, some still have difficulty in paying their medical bills. Medicare pays considerably less than the full cost of care; the amounts approved for payment are substantially below the health-care providers’ actual fees; there are annual deductibles and coin-

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surance requirements that beneficiaries must meet; and many health-care expenses are not covered, such as hearing aids and eyeglasses. As a result, the majority of Medicare beneficiaries purchase supplemental policies to provide additional coverage. However, some beneficiaries do not purchase a supplemental policy because of cost. As a result, some beneficiaries must pay sizable amounts out of pocket because of a chronic health condition. Some aged persons experience extreme depression and commit suicide. The suicide rate among the aged is higher than that of the general population. Experts believe that some elderly commit suicide because of lack of money, forced retirements and the loss of a job, rapid urbanization and technological change that can make some older people feel useless, cutbacks in pensions and medical expense benefits, poor health, and increased acceptance of the idea that terminally ill people should be able to take their own lives.

Long-Term Care Many older Americans will spend some time in a nursing home. A study by the U.S. Department of Health and Human Services found that people who reach age 65 will likely have a 40 percent chance of entering a nursing home. About 10 percent of the people who enter a nursing home will stay there five years or more.12 Most older patients in nursing homes are there because of incontinence, memory disorders, immobility from a hip fracture or arthritis, or senility. In addition, many nursing-home residents have Alzheimer’s disease. The cost of long-term care is staggering. Most long-term facilities charge $70,000 to $100,000 or even more for each year of care. The Medicare program provides only limited assistance in paying for the cost of long-term care. The patient must require care in a skilled nursing facility, and only up to 100 days are covered. Custodial care is excluded altogether. In addition, because of cost and limited incomes, the majority of retired workers do not have long-term care insurance. Depending on the daily benefit amount and age of the applicant, annual long-term care premiums for people age 65 or older can be $3,000, $4,000, or some higher amount. Most retired people cannot afford these high premiums. As a result, many older persons who need nursing-home care apply for coverage under the Medicaid program, which should not be confused with Medicare. Medicaid is a state and federal welfare program that has a stringent means test and complex eligibility requirements. Many applicants do not initially qualify for long-term care under Medicaid until they spend down their financial assets so that the means test can be satisfied. For example, Nebraska limits the financial assets of Medicaid recipients to $2,000. Thus, it is not surprising that many older people are reduced to poverty because of the cost of long-term care.

High Property Taxes Although many aged homeowners have their homes paid for by the time they retire, the property taxes they pay can be a heavy financial burden. Although the states have

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homestead exemptions or property tax relief for older people with limited incomes, many older homeowners do not qualify because their incomes are slightly above the income limit. As a result, consumption spending must be reduced to pay these taxes. Also, many older retired people, especially those with incomes below the poverty level, do not own their homes and must rent. The property taxes are merely shifted from the landlords to the tenants in the form of higher rents. Although aged homeowners receive an income-tax deduction when they file an itemized federal and state income tax return, older renters cannot take advantage of this deduction even though they are paying the property taxes in the form of higher rents. In recognition of the heavy property tax burden on the aged, the states provide for full or partial property tax relief to low-income, aged homeowners. However, as stated earlier, many do not qualify because their incomes are slightly above the income limit.

Inflation Inflation can also cause considerable financial hardship to older retired people. The costs of food, housing, clothing, medical care, utilities, and gasoline have substantially increased over time. Because of limited incomes, the aged tend to spend a higher proportion of their incomes on food, compared with the general population. The aged also spend a larger proportion of their incomes on medical care. Although Social Security benefits are adjusted each year for measurable changes in the Consumer Price Index, the benefits provide only a minimum floor of income and are not designed to meet all of the income needs of beneficiaries.

Other Financial Problems Many low-income elderly must deal with other financial problems that add to their economic insecurity. Low-cost subsidized housing is in short supply in many communities. Many aged persons cannot afford automobiles, and public transportation may be inadequate, especially in smaller communities and rural areas. In addition, the aged are often exploited by unethical salespeople promoting speculative investments, inappropriate types of life insurance, complex and unsuitable annuities, deceptive home repairs, and Internet scams.

Abuse of the Elderly Another part of the old-age problem is abuse of the elderly. An increasing number of older people report being abused. The abuses can be neglect or abandonment by caregivers, physical abuse, emotional abuse, health-care fraud and abuse, and financial exploitation. One estimate is that 500,000 to 1 million incidents of elderly abuse are reported to the authorities each year. However, since many incidents go unreported, the actual number is undoubtedly much higher.13 Most abusers are adult children or other relatives, spouses, providers of services, friends, and neighbors. In many cases, the abusers have serious personal problems,

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such as drug or alcohol addiction, money problems, mental illness, or unemployment. In some cases, the abusers, such as an adult son or daughter, have been the victims of violence in their youth.

Employment Problems of Older Workers The economic problems of old age cannot be separated from the employment problems of older workers. The economic insecurity experienced by many retired people can be traced directly to the employment problems they experienced prior to retirement. Thus, many older workers carry into retirement the same issues of economic insecurity, including the loss of income and insufficient income, that they were experiencing for years prior to their actual retirement. Although age 65 is thought to mark the beginning of old age, the employment problems of workers ages 55 to 64 must also be considered. The employment problems of older workers are summarized as follows: • Massive Job Losses. Millions of older workers have permanently lost their jobs during the past two decades due to widespread layoffs during business recessions, outsourcing of jobs overseas by major corporations, competition from foreign countries, structural changes in basic industries such as automobiles and steel, shifts from manufacturing jobs to service jobs, and permanent reduction in demand for certain products. Many plants have closed, and numerous corporations have permanently reduced the size of their labor force. As a result, the local economy may be depressed, and job opportunities at high wages for displaced older workers may be limited. • Loss of Health Insurance. During the financial meltdown and severe recession that occurred in the United States in 2008 and 2009, millions of older unemployed workers also lost their employer-sponsored group health insurance plans. Because of the substantial increase in health insurance premiums, many corporations have discontinued providing health insurance to older workers under age 65 who have been laid off or who have voluntarily elected early retirement. Other corporations with such plans have substantially increased the premiums that early retirees must pay, which makes it more difficult for many of them to retain their coverage. • The problem of the loss of health insurance by many early retirees may decline in the future because of the new Affordable Care Act signed into law on March 23, 2010. One provision in the new law provides for a temporary reinsurance program that will help offset the costs of health insurance coverage for companies that provide health insurance coverage to early retirees ages 55 to 64. • Housing Problems. Many older workers nearing retirement have higher mortgage debt than previous generations, which can aggravate economic security during retirement because of the problem of high additional expenses. Also, many older workers have lost their homes recently because of the collapse of the housing market and the increase in foreclosures during the severe 2008 and 2009 recession. As stated earlier, millions of older workers lost their jobs involuntarily, which made it financially difficult for many of them to continue mortgage pay-

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ments. The housing market collapsed, and mortgage balances often exceeded the market value of the home. As a result, many older homeowners defaulted on their mortgage payments. • Longer Duration of Unemployment. Although older workers have lower unemployment rates than the national average, the duration of their unemployment is considerably longer than that for younger workers. Older workers, however, are less likely to leave their jobs voluntarily, which partly explains the lower unemployment rates. • Older Minority Workers. Older minority workers often experience serious labor market problems because of the combination of low-paying jobs and unemployment or underemployment. Many older minority workers are employed in low-paying jobs with limited advancement opportunities. Also, older black and Hispanic adults generally experience higher unemployment rates than the national average. As a result, many unemployed minority workers experience considerable economic insecurity. • Age Discrimination in Employment. Despite federal legislation prohibiting age discrimination, subtle age discrimination in employment still exists. The Equal Employment Opportunity Commission receives numerous complaints each year from older workers. These complaints include refusal to hire or promote, wage inequities, discrimination in employee benefits, job assignments, sexual harassment, layoffs, and numerous additional factors. • Obsolescence of Job Skills. Many workers experience obsolescence of their work skills as they grow older. Older workers near retirement generally have fewer financial incentives to participate in training programs that would upgrade their work skills and earnings. • Displaced Homemakers. Displaced homemakers typically are older women who have spent most of their adult lives as homemakers and are suddenly forced to enter the job market because of divorce or death of their husbands. Displaced homemakers generally lack marketable skills for high-paying jobs and must often accept lower-paying positions. • Less Mobility. Older workers are less mobile than younger workers and are less likely to move voluntarily from one job, residence, or occupation to another. The unwillingness to relocate geographically often makes it difficult for them to find new jobs. Older workers often prefer to remain in high unemployment areas rather than relocate because of home, families, friends, and emotional attachment to the area.

Reducing Economic Insecurity During Retirement Several private and public programs and techniques are currently used to reduce economic insecurity during retirement. The most important include the following: • Part-time employment • Retirement planning programs • Social Security benefits

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• Medicare benefits • Individual retirement accounts (IRAs) • Private pensions and other government pension plans • 401(k) plans • Long-term care insurance • Supplemental Security Income (SSI) • Tax relief • Reverse mortgages • Elder-care benefits • Federal legislation

Part-Time Employment Part-time employment beyond age 65 is a valuable way to reduce economic insecurity during retirement. Part-time employment permits older people to work and supplement their limited retirement incomes. Poor health or the desire for additional leisure may make full-time work unattractive to older workers; however, many older workers are able to work part time and make a valuable contribution to the sustaining and strengthening of our economic system. The income from part-time employment often means the difference between a poverty level of living and a much higher standard of living. A variation of part-time employment is gradual retirement. Under this approach, employment is not abruptly terminated; instead, partial employment and partial retirement are combined so that older workers can obtain the advantages of both continued employment and retirement. Several approaches to gradual retirement are possible. First, older workers can be given an extended leave in the last year of employment or more time off each year for a period of three-to-five years prior to retirement. Another approach is to allow workers to transfer to less demanding work or to part-time employment; many firms can accommodate older workers in this manner without a formal designation of the workload as gradual retirement. Finally, for professional workers and executives, gradual retirement may take the form of rehiring them after retirement on a temporary basis to perform specific jobs for which their skills qualify them. The older employees benefit, since they can accept work on terms that suit them. And management also benefits, since younger workers can be promoted, and the employer still retains the services and skills of valuable older employees; in addition, management can choose to employ only those workers considered valuable.

Retirement Planning Programs To help workers prepare for retirement, many firms today provide some type of preretirement training program or advice to retiring workers. The programs provide useful information to workers about retirement. Topics discussed may include investment options for 401(k) plans and other retirement plans, health insurance options,

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money management, physical aspects of aging, mental health in later years, housing and nutrition problems, living arrangements in later life, the use of leisure time, and volunteer work. Adjusting to retirement is often closely related to the preretirement training. Older workers may not be aware of the extensive changes that will occur after retirement. The decision to retire may present some uncertainty, and the necessary adjustments during retirement are more easily made if these uncertainties are removed. Counseling by trained experts in gerontology can often mean the difference between a successful retirement and an unsuccessful one.

Social Security Benefits Both OASDI retirement benefits and Medicare benefits are extremely important in reducing economic insecurity for the aged. Retirement benefits replace part of the loss of earned income from retirement, while the Medicare program helps meet the problem of additional expenses in old age because of high medical bills. Retirement Benefits

About 90 percent of the population age 65 and over were receiving Social Security benefits at the beginning of 2010. The benefits are worth a substantial amount in terms of private annuity equivalents. According to the National Academy of Social Insurance, OASDI retirement benefits are worth about $225,000 based on the average monthly benefit of $1,045 paid to retirees in January 2007. In other words, a beneficiary, age 65, who wished to purchase a private annuity that guaranteed that amount for life, with a cost-of-living adjustment and continuous payments to a surviving spouse, would have to pay about $225,000.14 The OASDI program is also extremely effective in reducing the number of beneficiaries who sink into poverty. In 2010, the poverty rate for the aged 65 and over was 9 percent. Without Social Security, an additional 14 million seniors would be poor, and the poverty rate would increase sharply, to about 45 percent.15

Medicare Benefits Almost all retired Americans, age 65 or over, are covered under the Medicare program, which pays a large portion of medical expenses for chronic illnesses. The Medicare program has four major parts: • Hospital Insurance (Part A) provides coverage for inpatient hospital stays and other benefits as well. • Medical Insurance (Part B) covers physicians’ services and other benefits. • Medicare Advantage Plans (Part C) are private health insurance plans that are part of the Medicare program. • Medicare Prescription Drug Coverage Plans (Part D) are private plans that cover prescription drugs outside the hospital.

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The Medicare program reduces the economic insecurity that the aged would otherwise experience by relieving them of a large part of the financial burden of crushing medical bills. Medicare is discussed in greater detail in Chapter 10.

Individual Retirements Accounts (IRAs) Millions of Americans have established individual retirement accounts (IRAs) to supplement their retirement income. IRAs are individual retirement plans that allow workers with earned income to save for retirement with favorable tax advantages. There are several types of IRA plans, including the following: • Traditional tax-deductible IRA • Roth IRA • Spousal IRA Traditional Tax-Deductible IRA

A traditional IRA allows workers to deduct part or all of their IRA contributions on their income tax returns. The investment income accumulates income tax free on a tax-deferred basis, and the distributions are taxed as ordinary income. Workers who are not active participants in an employer-sponsored retirement plan, or who have modified adjusted gross income below certain thresholds, can establish a traditional IRA. To be eligible, workers must have earned income (not investment income) and be under age 70½. For 2011, single taxpayers with modified adjusted gross incomes of $56,000 or less can contribute a maximum of $5,000 into a traditional IRA ($6,000 if age 50 or over). Married couples filing jointly with modified adjusted gross incomes of $90,000 or less can make a fully deductible IRA contribution up to $5,000 ($6,000 if age 50 or over). The IRA contributions are indexed for inflation in increments of $500. Maximum annual contributions are gradually phased out for single taxpayers with modified adjusted gross incomes between $56,000 and $66,000, and for married taxpayers with modified adjusted gross incomes between $90,000 and $110,000. With certain exceptions, distributions before age 59½ are subject to a 10 percent tax penalty. However, the 10 percent penalty does not apply to distributions to pay qualified higher education expenses, or to pay qualified acquisition costs for a firsttime homebuyer ($10,000 maximum). Roth IRA

A Roth IRA is another type of IRA that provides substantial tax advantages. The annual contribution limits discussed earlier for a traditional IRA also apply to a Roth IRA. The annual contributions are not tax deductible; the investment income accumulates income tax free; and qualified distributions at retirement are not taxable if certain requirements are met. Qualified distributions are received income tax free if the distribution is made after a five-year holding period beginning with the first tax

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year for which a Roth contribution is made, and the distribution is made for any of the following reasons: (1) the individual is age 59½ or over, (2) the individual is disabled, (3) the distribution is paid to a beneficiary or to the estate after the individual’s death, or (4) the money is used for a first-time home purchase (maximum of $10,000). The income limits for a Roth IRA are generous. For 2011, the maximum Roth IRA contribution is limited to single taxpayers with modified adjusted gross incomes less than $107,000, and to married couples filing jointly, with modified adjusted gross incomes less than $169,000. Maximum contributions are phased out for single taxpayers with modified adjusted gross incomes between $107,000 and $122,000, and for married couples filing jointly with adjusted gross incomes between $169,000 and $179,000. The income limits are also indexed for inflation. Spousal IRA

In many families, a married worker is an active participant in the employer’s retirement plan, but the other spouse is not. A spousal IRA allows a spouse who is not in the paid labor force or is a low-earning spouse to make a fully deductible contribution to a traditional IRA up to the maximum annual limit even though the other spouse is covered under a retirement plan at work. For 2011, the maximum contribution for a spouse who is not an active participant is $5,000 ($6,000 if age 50 or over). The full deduction is limited to married couples with modified adjusted gross incomes less than $169,000 (indexed for inflation). The deduction is phased out for married couples with modified adjusted gross incomes between $169,000 and $179,000 (indexed for inflation).

Private Pensions and Other Government Pension Plans Private pensions and other government pension plans are extremely important in reducing economic insecurity during retirement, especially for employees with average or above-average earnings. The plans provide an additional layer of income on top of Social Security benefits, which provide only a minimum floor of protection. Most employer-sponsored retirement plans today are defined-contribution plans in which the contribution rate is specified, but the actual retirement benefit will vary for each employee depending on the age of entry into the plan, investment returns, and age of retirement. For example, in a money-purchase plan, the plan may specify a contribution rate of 6 percent of salary, which is paid by both the employee and employer. Accounts are set up for each participant, and the contributions are deposited into the participant’s account. When the worker retires, the account value is used to provide retirement benefits. Defined-benefit pension plans are also important in reducing economic insecurity during retirement. Although defined-benefit plans have declined in relative importance over time, they pay guaranteed benefits to millions of retired workers each month. Defined-benefit pension plans are plans where the retirement benefit is known in advance, but the employer’s contributions for the worker will vary depending on the amount needed to fund the required benefits. Retirement benefits are based on for-

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mulas that, combined with Social Security, will generally replace 50 to 60 percent of the worker’s gross earnings prior to retirement. The benefit amount is typically based on the worker’s earnings, years of service, and age of retirement. Government retirement plans are also important in providing financial security to millions of retired federal employees and state and local government employees. These plans include the Federal Employees Retirement System, Civil Service Retirement System, and defined-contribution and defined-benefit plans of state and local governments. These plans are discussed in greater detail in Chapter 17. Pension plans have an important macroeconomic impact on the economy. Pension contributions are an important source of private savings; they affect economic growth and development; and pension fund investments have an enormous influence on the financial markets and concentration of economic power. Finally, pension plans have a significant impact on the redistribution of income, labor mobility, early retirement, and employment opportunities for older persons. Private Pension Problems

Although private pension plans have considerable potential for reducing economic insecurity for retired workers, certain problems are present. They include the ­following: 1. Incomplete Coverage of Labor Force. Coverage of the labor force by pension plans is limited and incomplete. In March 2010, only 65 percent of all workers in private industry had access to employer-sponsored retirement plans, and only 50 percent actually participated in the plans.16 The incomplete coverage of the labor force is due to several factors: • Pension plans are expensive, and many small firms cannot afford to provide them for their employees. • Membership in labor unions has declined over time. Labor unions in the past have aggressively bargained for an increase in coverage and benefits. • Changes in pension laws have made defined-benefit pension plans more costly, including more liberal vesting rules and eligibility requirements, tougher funding standards, and complex regulations. As a result, many firms have substituted defined-contribution plans, such as 401(k) plans, profit-sharing plans, and thrift plans, for the more costly defined-benefit plans. • Employment in the services industry has increased substantially over time. Firms in the services industry often are financially weaker and less inclined to install pension plans than larger manufacturing firms. • To reduce labor costs, corporations increasingly are using part-time, temporary, or subcontracted employees who may not be eligible to participate in the company’s retirement plan. As stated earlier, not all employees participate in employer-sponsored retirement plans. There are several reasons for nonparticipation. First, some employees are initially ineligible because they have not yet met the age or service requirements of

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the plan. To be eligible, qualified retirement plans typically require participants to be 21 or older and have at least one year of service with the company. Second, other employees make a voluntary decision not to participate; some eligible workers believe they cannot participate because they need all of their income to meet their living needs, or that their earnings are too low to contribute to the plan. Finally, many employees are part-time workers, and pension plans are permitted to exclude workers who work fewer than 1,000 hours per year. 2. Lower Benefits for Women. Women are more likely to receive lower private pension benefits than men, which makes it more difficult for them to attain a reasonable standard of living during retirement. According to the Employee Benefit Research Institute (EBRI), in 2009, the median annual pension benefit for people age 65 and over was $9,144 for males and $6,747 for females.17 The lower benefits for females can be explained by the lower earnings of females when compared with male earnings and the shorter average period of employment. Females are more likely than males to be working in lower-paying occupations, and their earnings increase less rapidly than those of males. Also, women enter and exit the labor force more frequently than men because of family responsibilities. Because private pension benefits are related to work earnings and length of employment, women generally receive lower monthly benefits than men. Thus, other factors being equal, economic insecurity for older women is likely to be greater because of inadequate pension benefits. 3. Limited Protection Against Inflation. Millions of workers receive monthly retirement benefits from defined-benefit pension plans and from defined-contribution plans. Most plans provide limited protection against inflation. The result is that the real purchasing power of the benefits declines during a period of rising prices. For example, a 4 percent annual inflation rate will reduce the real purchasing power of a $1,000 monthly benefit to $500 in 18 years. The reduction in purchasing power could dramatically erode the economic security of a retired worker who started to receive pension benefits at age 65 but lives to age 83. Although defined pension plans generally adjust the retirement benefits for inflation over time, the average adjustment may be considerably less than the rate of inflation; thus, real incomes are eroded over time. The primary obstacle to full protection against inflation is cost. An inflation hedge of 1 percent annually could increase the cost of the plan by 8 to 10 percent. Likewise, most participants in employer-sponsored retirement plans are in definedcontribution plans. As stated earlier, the benefit amount depends on the value of the employee’s account at retirement. Many workers do not annuitize their account balances but take the funds and invest them on their own. Annuitizing means that the account balance is converted to a lifetime income for the annuitant with a life insurer. Many annuities, however, pay only fixed benefits, which generally are not adjusted for inflation. Most annuities have a cost-of-living option, which may increase the monthly benefits based on the Consumer Price Index or another index. However, although this option provides an inflation hedge, the initial monthly benefits are significantly lower than a fixed annuity without this option. 4. Spending Lump-Sum Pension Distributions. Millions of workers in employersponsored retirement plans change jobs before retirement. As stated earlier, the ma-

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jority of participants today are in defined-contribution plans. When a worker changes jobs, the account balance can be left in the plan, rolled over into an individual retirement account or other qualified retirement plan, or taken as a lump-sum distribution. Many departing workers take lump-sum distributions, especially younger workers, and part or all of the distribution is spent rather than saved for retirement. As a result, economic insecurity during retirement may be increased for these workers because of insufficient savings. According to one study by the EBRI, about 16.2 million working-age Americans reported that they had received a lump-sum distribution when changing jobs, through April 2006. The average distribution was relatively small ($32,219 in 2006 dollars), and the median amount was only $10,000. About 60 percent of the workers who took a lump-sum distribution stated that they did not roll over the entire distribution into an individual retirement account or other qualified plan but spent part of the distribution.18 The distributions were spent on consumption needs, home purchases, starting a business, and paying down debt. Several problems are immediately present from the spending of a lump-sum pension distribution. First, economic insecurity is increased during retirement because retirement benefits are lower. The cash is spent, and the pension benefit, if any, is a lower amount. Second, there are substantial tax penalties for premature distributions taken before age 59½. A lump-sum distribution is taxed as ordinary income, and, with certain exceptions, a 10 percent penalty tax also applies. Finally, the benefits of compound interest on a tax-deferred basis are lost.

401(k) Plans Many employers have 401(k) plans that enable millions of workers to save for their retirement on a tax-deferred basis. These plans are called qualified cash or deferred arrangements that allow eligible workers the option of contributing to the plan or receiving the funds as cash. The tax savings are significant. Unless paid in cash, 401(k) contributions are not taxable as income to plan participants, and investment income accumulates on a tax-free basis. Basic Characteristics

A 401(k) plan can be established that includes employer and employee contributions, or employee contributions alone. In a typical plan, both the employer and employee contribute to the plan, and the employer matches part or all of the employee’s contribution up to a certain limit. For example, for each dollar contributed by the employee, the employer may contribute 25 cents or 50 cents, or some higher amount. The employer’s contributions are not taxable as income to the employee, and the employee’s contributions are paid with before-tax dollars. As such, the tax savings provide a strong financial incentive to save for retirement on a favorable tax-deferred basis. Eligible employees can voluntarily elect to have their salaries reduced if they participate in a 401(k) plan (called an elective deferral). For 2011, the maximum limit on elective deferrals in a 401(k) plan for an eligible employee is $16,500. Employees age

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50 or older can make an additional catch-up contribution of $5,500. The maximum dollar limits are indexed for inflation in increments of $500. As stated earlier, the employee’s contributions are made with before-tax dollars, investment income accumulates income tax free, and employer contributions are not taxable to the employee. However, Social Security taxes must still be paid on the amounts contributed to the plan. The distributions are taxed as ordinary income when withdrawals are made. Employees typically have a choice on how the 401(k) contributions are invested. Typical investments include money market funds, common stock funds, international funds, bond funds and fixed-income funds, real-estate funds, stable-value funds, and others. Most plans allow participants to move investments from one fund to another at little or no cost. Investment Mistakes That Jeopardize Economic Security

In 401(k) plans and other defined-contribution plans, the investment risk falls squarely on plan participants. Research studies show participants in 401(k) plans often make serious investment mistakes, which can jeopardize their economic security. Three egregious mistakes in are worth noting: • Many older workers nearing retirement are too heavily invested in common stocks. During the financial meltdown and severe recession that occurred in the United States in 2008 and 2009, employees lost billions of dollars because of the brutal stock market decline that substantially reduced their 401(k) account balances. The stock market declined by more than 50 percent at one point during that period. According to a study by the EBRI, many older workers nearing retirement (ages 56–65) experienced losses of 25 percent or more in their 401(k) accounts in 2008. The EBRI study showed that nearly one in four participants ages 56–65 had more than 90 percent of their account balances invested in equities at year-end 2007, and more than two in five had 70 percent in equities.19 • Many eligible employees do not participate in their employers’ plans, or if they do, they contribute less than the maximum allowed. For example, assume that the plan allows employees to contribute 4 percent of their salary into a plan, which is matched 50 percent by the employer. There is an immediate 50 percent return on the employee’s contribution. An employee who fails to participate is passing up “free money” from the employer’s contribution. Likewise, many employees limit their contributions to less than the maximum allowed. For example, a worker may contribute only 2 percent of salary instead of 4 percent. Once again, there is a partial loss of the employer’s contribution, and the accumulated amounts at retirement are reduced, which results in a smaller amount of retirement income. • Some employees still continue to invest heavily in company stock. Many corporations have savings or thrift plans that allow eligible employees to buy common stock at significant discounts. The incentive to buy stock at a discount induces some employees to overinvest in company stock. If the company later experi-

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ences serious financial problems or bankruptcy, stock values could be wiped out or significantly reduced. For example, thousands of employees of the Enron Corporation invested heavily in the company’s common stock. Enron filed for bankruptcy in 2001. In addition of the loss of their jobs, thousands of employees had a large part of their life savings wiped out as a result of the bankruptcy.

Long-Term Care Insurance Many older Americans will spend some time in a nursing home. As stated earlier, 40 percent of the people reaching age 65 will enter a nursing home, and the cost of longterm care is staggering. Also noted earlier, long-term care facilities charge $70,000 to $100,000 or even more for each year of care. As a result, many older Americans purchase long-term care policies to meet the financial burden of an extended stay. Long-term care policies sold today generally have the following characteristics: • Several types of policies. Policies generally can be classed into three categories. A facility-only policy covers care in a nursing facility, assisted living facility, and other facilities. A home health-care policy covers care received outside of a facility. A comprehensive policy covers care in a nursing facility and other facilities and also makes home health care available on an optional basis. • Guaranteed renewable. The contracts are guaranteed renewable. Once issued they cannot be canceled, but rates can be increased for broad classes of the insured. • Choice of benefits. Applicants can select the level of coverage desired, such as $300 daily and a maximum benefit period of five years. • Elimination period. Coverage can be purchased with an elimination period, which is a waiting period during which time benefits are not paid. Common elimination periods are 30, 60, 90, or 180 days. Longer elimination periods can substantially reduce premiums. • Benefit triggers. The insured must meet one of two benefit triggers to receive benefits. The first trigger requires the insured to be unable to perform a certain number of activities of daily living (ADLs), which typically are eating, bathing, dressing, transferring from a bed to a chair, using the toilet, and incontinence. The second trigger is that the insured suffers from a severe cognitive impairment, such as dementia, and needs supervision. The insured may have Alzheimer’s disease, severe memory impairment, or is someone who becomes disoriented and needs supervision. • Inflation protection. Some type of inflation protection can be added as an optional benefit. Many insurers allow policyholders to increase the daily benefit each year based on increases in the Consumer Price Index (CPI). Another method is to automatically increase the initial daily benefit each year at some specified rate, such as 5 percent annually. Adding an automatic benefit increase, however, is expensive and will increase the annual premiums significantly. • Nonforfeiture benefits. Most insurers offer nonforfeiture benefits as an optional benefit, which pays benefits if the insured lets the policy lapse. Common nonforfeiture benefits are a return of premiums or a shortened benefit period. Under the

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return-of-premium option, the insured receives cash after the policy lapses, which is a percentage of the total premiums paid. Under a shortened benefit period, coverage continues, but the benefit period or maximum dollar amount is reduced. Long-term care insurance has the major advantage of reducing or eliminating the crushing financial burden of an extended stay in a nursing home. However, long-term care insurance has two major disadvantages as a practical technique for reducing economic insecurity among the elderly. First, long-term care policies are expensive. Depending on the daily benefit amount and the applicant’s age, annual premiums can easily be $3,000, $4,000, or some higher amount. Many older people with limited incomes cannot pay these high premiums and are thus uninsured for long-term care. Second, the elderly face considerable financial risks over time if premiums are increased. Most long-term care policies are guaranteed renewable, which allows insurers to increase premiums for broad classes of insureds. Also, in many policies, the insured has the right to increase the daily benefit amount each year based on the increase in the CPI. However, the total premium will also increase each year if the insured exercises his or her right to increase the daily benefit. As a result, many older policyholders may be faced with substantial premium increases over time, which makes it more difficult for them to keep their policies.

Supplemental Security Income (SSI) Some older people with low incomes and limited financial assets may be eligible for monthly cash benefits under the Supplemental Security Income (SSI) program for the aged, blind, and disabled. SSI is a public assistance program with a stringent means test. The program pays supplemental benefits to eligible persons who are receiving inadequate OASDI benefits or are not eligible for benefits under the OASDI program. In 2011, the SSI program paid maximum monthly federal benefits of $674 to an eligible individual with no other source of income and $1,011 to an eligible individual with an eligible spouse. To qualify for benefits, older applicants must be 65 or over and meet a means test. The limits are $2,000 in countable assets for an individual and $3,000 for a couple. In determining eligibility, certain assets are excluded, which include the home, life insurance policies with a face value of $1,500 or less, one vehicle, burial plots, and up to $1,500 in burial funds ($3,000 for a couple). The SSI program is part of the overall system of public assistance in the United States. The program is analyzed in greater detail in Chapter 16.

Tax Relief Low-income older retirees also receive favorable tax treatment under the Internal Revenue Code and state and local laws. Examples are an additional standard deduction for persons age 65 or older and a retirement income credit for low-income persons. A state or city may also provide property tax relief or a homestead exemption to eligible homeowners. The tax relief may be in the form of a reduction in the assessed value of the home or an income tax credit or tax rebate, usually on the income tax return.

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Reverse Mortgages Older people may own their homes or have a large equity in them. Many financial institutions make reverse mortgages available to older homeowners. A reverse mortgage is a special type of home loan that allows the homeowner to convert part of the equity in the home into cash. The Federal Housing Administration (FHA) in the Department of Housing and Urban Development (HUD) has a reverse mortgage program called the Home Equity Conversion Mortgage (HECM) program, which provides mortgage insurance.20 The equity can be used to pay monthly cash income to the homeowner, to establish a line of credit, or some combination. Most reverse mortgages issued at the present time are insured under the HECM program. Reverse mortgages are typically used to pay off a second mortgage, which reduces monthly cash payments, or to pay medical bills, debts, and daily living expenses. The homeowner does not make monthly payments. The loan is not required to be repaid as long as the homeowner lives in the property. The loan is repaid when the homeowner dies, moves, or sells the home. Mortgage insurance guarantees that (1) the homeowner will not outlive the reverse mortgage, (2) the homeowner or heirs will not be liable if the mortgage balance exceeds the value of the home (also called an “underwater” mortgage), and (3) the FHA takes over the loan if the lender has financial problems. Eligibility Requirements

Applicants for a reverse mortgage must meet certain eligibility requirements. Homeowners must be at least age 62, own the property outright or have a small mortgage balance, occupy the property as the principal residence, not be delinquent on any federal debt, and participate in a consumer information session given by an approved HECM counselor. The lender may require payment of the remaining mortgage balance before the loan is granted. However, current income, health status, credit history, and previous bankruptcy are not considered. Mortgage Amount

The mortgage amount is based on the borrower’s age, current interest rate, and appraised value of the home or FHA mortgage limits for the area, whichever is less. Generally, the higher the value of the home, the older the borrower’s age, and the lower the interest rate, the greater the amount that can be borrowed. The maximum HECM mortgage limit is $625,000 at the time of writing. Closing costs for the loan can be included in the reverse mortgage loan. Online calculators are available to determine the amount the homeowner can borrow. Repayment of Loan

The HECM loan must be repaid in full when the borrower dies or sells the home. The loan also becomes due if (1) the homeowner does not pay property taxes or hazard

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insurance or violates other obligations, (2) the homeowner moves permanently to a new principal residence, (3) the homeowner, or the last borrower, fails to live in the home for 12 months in a row, such as in the case of a patient confined to a nursing home for 12 consecutive months or longer, or (4) the homeowner allows the property to deteriorate and does not make necessary repairs. Advantages and Disadvantages

Reverse mortgages have both advantages and disadvantages. First, reverse mortgages enable older homeowners who need additional income to remain in their homes; installment payments are not required, and economic insecurity is reduced. Second, if the reverse mortgage is structured as monthly income payments, the homeowner cannot outlive the reverse mortgage even though the loan proceeds may be exhausted. Finally, the homeowner is not liable if the value of the home declines and is less than the mortgage balance. This is particularly important in the wake of the burst of the housing bubble and significant ensuing decline in housing prices during the 2008 and 2009 economic downswing. At the time of writing, millions of homeowners in the United States own homes whose market value is less than the remaining mortgage balance. Although reverse mortgages have the potential for reducing economic insecurity during retirement, certain disadvantages must be recognized. First, reverse mortgages are complex financial instruments that are difficult to understand; counseling is required before the mortgage is granted; and older retired people as a group are reluctant to go into debt. As such, reverse mortgages may not appeal to some older retired homeowners who need extra income. Second, borrowers pay relatively high acquisition costs to obtain a reverse mortgage. An HEMC loan includes numerous fees, including an origination fee, monthly servicing fee, closing costs, mortgage insurance premium, title insurance, and other fees. For example, assume that a hypothetical 70-year-old borrower owns a $625,000 home and is eligible for a maximum loan of $387,500. Total fees and closing costs would be $28,897, or about 7.5 percent of the amount borrowed.21 In addition to the fees, interest must also be paid on the loan. Many large lenders have eliminated the origination fee and monthly service fee in order to be more competitive. Referring back to the earlier example, elimination of origination and monthly servicing fees would reduce total acquisition costs to $17,900, or 4.61 percent of the amount borrowed.22 The acquisition costs, however, are still relatively high. Third, if the reverse mortgage is structured as monthly income payments, a severe financial disincentive to move and relocate is created. If the homeowner sells the home and wants to relocate to another area, the reverse mortgage payments will terminate. Although the homeowner may end up with some cash after the house is sold, the cash proceeds will not last indefinitely. Finally, another disadvantage is that the loan must be repaid if the homeowner, or last borrower, fails to live in the house 12 months in a row. This is particularly important for a homeowner who is confined to a skilled nursing facility beyond

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12 months. A patient with a reverse mortgage would be faced with the problem of repayment of the loan after 12 consecutive months in the nursing facility, which could require sale of the home at a time when the housing market is severely ­depressed.

Elder-Care Benefits People in the work force often must care for aged parents or older sick relatives. Aged parents and older relatives may need help with shopping, transportation to medical appointments, and help filling prescriptions. Some aged parents require round-the-clock medical care or care in an assisted living facility. In addition, many sick aged parents require geriatric care management. As a result, adult children in the work force can experience emotional and physical stress; job performance may decline and overtime may be refused. Some employees must quit their jobs to care for sick relatives, and others refuse promotions or transfers to a new location. In addition, because of increased labor mobility, family members often live hundreds or thousands of miles away from a sick parent or relative, which aggravates the problem of care. The substantial increase of women with children who are in the labor force also compounds the problem, since women are the traditional caregivers for sick parents or relatives. In many cases, working women with young children experience severe emotional, physical, and financial stress while caring for an aged parent or relative. To reduce employee attrition and loss of productivity, many employers have established elder-care programs that provide considerable assistance to caregivers. Elder-care benefits are employer benefits or programs sponsored by employers that enable workers to care for sick parents or relatives with the objective of reducing employee absenteeism, job stress, and decreased worker productivity. Although elder-care benefits vary among employers, some common benefits include the following: • Flextime, where workers have considerable flexibility in determining work hours • Telecommuting, where employees work at home instead of commuting to work • Extended family leave to care for aged parents or relatives • Part-time employment or job sharing, where two employees share in one job • Information on a wide variety of topics, such as health care for the elderly, availability of homemaker services, financial management, assisted living facilities, and nursing homes • Referral services to appropriate agencies in the community • Employee assistance programs, which include counseling to employees to help with stress and other problems As a result of employer assistance, needed care can be provided more easily to aged or sick relatives, stress is reduced, and job performance is improved.

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Federal Legislation In addition to the preceding approaches, federal legislation has been enacted to protect older workers and reduce economic insecurity. The federal Age Discrimination in Employment Act of 1967 prohibits employers, employment agencies, and labor unions from discriminating against older workers in hiring, discharge, compensation, and other terms of employment. With certain exceptions, the original act applied to workers between ages 40 and 65. The act was later amended in 1978 to extend protection against age discrimination in employment to workers up to age 70 and eliminated the upper age limit entirely for most federal workers. The act was again amended in 1986, and mandatory retirement at any age was prohibited for most jobs. Certain groups were temporarily excluded from the act for seven years, such as police officers, firefighters, prison guards, and tenured academic faculty. The Age Discrimination in Employment Act was later amended by the Older Workers Benefit Protection Act of 1990. The law generally prohibits employers from reducing employee benefits because of age unless the employer can show that the cost of the benefit for older workers is greater, such as in the case of life insurance. The law also specifies the rules that employers must follow when terminated employees are asked to voluntarily waive their rights to sue for age discrimination. The latter practice often occurs when employees are terminated as part of a reduction in the labor force. Despite the existence of the Age Discrimination in Employment Act, numerous older workers still report age discrimination. Common violations reported include refusal to hire, refusal to promote, and illegal termination. More effective law enforcement by both the federal and state governments undoubtedly can do much to reduce future age discrimination in employment.

Summary • The economic problem of old age consists of a growing proportion of older people, loss of earned income because of retirement, a longer retirement period, insufficient income and assets, poor health of some retired persons, high cost of long-term care, high property taxes, erosion of real incomes by inflation, and abuse of the elderly. • The period of retirement is growing because of the increase in life expectancy, early retirement, and a longer period of formal education. • Early retirement can aggravate economic insecurity during retirement because the period of productive work is reduced. As a result, the amount of accumulated assets in private pension plans and 401(k) plans is reduced. • The aged as a group are neither wealthy nor poor, but are economically diverse. Major sources of income to the aged are Social Security, work earnings, and public and private pensions. However, workers generally are not saving enough for a comfortable retirement.

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• Many aged have chronic health problems such as arthritis, heart disease, back conditions, and diseased joints. Many elderly are also faced with the cost of long-term care in an assisted nursing facility or skilled nursing facility. The cost of long-term care is staggering, and many retired Americans cannot afford the high premiums for long-term care insurance. • A number of techniques and programs can reduce economic insecurity during retirement. These approaches include part-time employment; retirement planning programs; Social Security benefits; Medicare benefits; income from individual retirement accounts (IRAs), private pensions, and 401(k) plans; long-term care insurance; Supplementary Security Income (SSI); tax relief; reverse mortgages; and elder-care benefits. • Private pension plans have a number of problems, including incomplete coverage of the labor force, lower benefits for women, limited protection against inflation, and the spending of part or all of lump-sum pension distributions by workers who change jobs. • Many participants in 401(k) plans make several investment mistakes that could jeopardize their financial security: older workers nearing retirement tend to be too heavily invested in common stocks; many eligible employees do not participate in their employers’ plans or contribute less than the maximum allowed; and some employees continue to overinvest in company stock. • To be eligible for long-term care benefits, the insured must meet one of two benefit triggers. The first trigger requires the insured to be unable to perform a certain number of activities of daily living (ADLs), which typically are eating, bathing, dressing, transferring from a bed to a chair, using the toilet, and being continent. The second trigger is when the insured has a severe cognitive impairment, such as Alzheimer’s disease, and needs supervision. • Many financial institutions make reverse mortgages available to older homeowners. A reverse mortgage is a special type of home loan that allows the homeowner to convert part of the equity in the home into cash. The equity can be used to pay monthly income to the homeowner, taken in cash, used to establish a line of credit, or some combination. • The federal Age Discrimination in Employment Act of 1967 prohibits employers, employment agencies, and labor unions from discriminating against older workers in hiring, discharge, compensation, and other terms of employment.

Review Questions 1. Identify the major factors that can cause economic insecurity during retirement. 2. Describe the financial position of the elderly age 65 and over with respect to income and assets. Why do many retired workers have relatively small amounts of financial assets? 3. Explain how early retirement can cause economic insecurity for some retired persons.

Application Questions  93

4. Why is the poverty rate relatively high for older widows? 5. Briefly describe the employment problems of older workers. 6. Explain the nature of the health problems of older retired persons. 7. Identify the major techniques that are currently used to reduce economic insecurity during retirement. 8. How effective are Social Security benefits in reducing economic insecurity during retirement? 9. Briefly explain the major problems that are present in private retirement plans. 10. Briefly describe the major disadvantages of long-term care insurance plans.

Application Questions 1. The Social Security Administration has several benefit calculators available on its Web site. The “Quick Calculator” will give you a rough estimate of your retirement benefits. Benefit estimates depend on your date of birth and on your earnings history. For security purposes, the calculator will not access your actual earnings record to obtain your past earnings. Instead, the calculator will estimate your earnings based on the information you provide. Although the calculator makes an initial assumption about your past earnings, you can change the assumed earnings after you complete and submit the form. You must enter the day of your birth, actual or estimated earnings for the current year, and your future retirement date (optional). The site can be accessed at www.socialsecurity.gov/OACT/quickcalc/. Using the “Quick Calculator,” estimate your Social Security retirement benefits. 2. Josh, age 25, is a marketing major who recently graduated from college and accepted a job with a global oil company. The company offers a number of employee benefit plans to its employees, including a 401(k) retirement plan. Under the plan, eligible employees can elect a salary deferral of up to 6 percent of compensation not to exceed $16,500 (2011 limit for participants under age 50). The company makes a matching contribution of 50 cents for each dollar contributed. The company requires an employee to be at least age 21 and have at least one year of service with the company to participate in the plan. Based on the preceding information, answer the following questions. Treat each event separately. a. Josh is ineligible to enroll in the 401(k) plan for one year. Assume that you are a financial planner and recommend that Josh should contribute to a Roth IRA during this period. Describe the major characteristics of a Roth IRA. b. Before Josh enrolls in a 401(k) plan, he would like know how the plan operates. Describe the major characteristics of a 401(k) plan. c. Josh decides to participate in the 401(k) plan and elects to defer only 3 percent of his salary because he wants to pay off his student loans. What advice would you give him? d. The company has a public stock offering and Josh has the opportunity to purchase common stock for his 401(k) plan at a 10 percent discount. What

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advice would you give Josh concerning the investing of 401(k) contributions in company stock? e. Assume that Josh attains age 62 and plans to retire at age 65. His latest 401(k) statement shows that 90 percent of the assets are invested in common stocks and 10 percent in fixed income and money market funds. What advice would you give Josh concerning his present asset allocation?

Internet Resources • Charles Schwab provides informative articles and information on retirement planning, annuities, and individual retirement accounts (IRAs). Visit the site at www.schwab.com • The Employee Benefit Research Institute (EBRI) is a nonprofit organization that makes available a wide variety of research studies on employer-sponsored retirement plans and other employee benefits. Visit the site at www.ebri.org • The Employee Benefits Security Administration (EBSA) is an agency of the U.S. Department of Labor that provides information and statistics on qualified retirement plans and unemployment insurance. Visit the site at www.dol.gov/ ebsa • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on Social Security and Medicare on its Web site. Visit the site at www.nasi.org • The National Council on Aging (NCOA) is a nonprofit service and advocacy organization in Washington, D.C. Its mission is to improve the lives of older Americans, especially people who are vulnerable and disadvantaged. Visit the site at www.ncoa.org/about-ncoa • The Pension Benefit Guaranty Corporation (PBGC) is a federal corporation that protects the retirement benefits of workers in defined-benefit pension plans. The site provides timely information on defined-benefit plans. Visit the site at www.pbgc.gov • Social Security Online is the official Web site for the Social Security Administration, which administers the Social Security (OASDI) program in the United States. The site provides updated information on retirement, survivor, and disability benefits and recent changes in the program. Visit the site at www.ssa.gov

Selected References Beam, Burton T., Jr., and John J. McFadden. Employee Benefits. 8th ed. La Crosse, WI: Dearborn Real Estate Education, 2007. Bureau of Labor Statistics News. United States Department of Labor. Employee Benefits in the United States, March 2010. Washington, DC, July 27, 2010. Employee Benefit Research Institute. “The Impact of the Recent Financial Crisis on 401(k) Account Balances.” EBRI Issue Brief no. 326, February 2009. ———. “Executive Summary: Lump Sum Distributions at Job Change.” Notes 30, no. 1, January 2009.

Notes  95 ———. “The 2010 Retirement Confidence Survey: Confidence Stabilizing, But Preparations Continue to Erode.” EBRI Issue Brief no. 240, March 2010. ———. “Source of Income Aged 55 and Over.” EBRI Databook on Employee Benefits, Chapter 7, updated October 2009. Greene, Kelly, and Anne Tergesen. “Reverse Mortgages Now Look Cheaper.” Wall Street Journal, April 17, 2010. National Academy of Social Insurance. Social Security: An Essential Asset and Insurance Protection for All. Social Security Brief no. 26, February 2008. ———. “The Role of Benefits in Income and Poverty.” This is an online source book that is periodically updated to highlight key facts about Social Security. National Council on Aging. A Look at Issues Facing Older Adults Ages 55 to 64: A Supplement to “Current Economic Status of Older Adults in the United States: A Demographic Analysis.” January 2010. Social Security Administration. Income of the Aged Chartbook, 2008. Office of Retirement and Disability Policy and Office of Research, Evaluation, and Statistics. Washington, DC, April 2010. ———. Income of the Population 55 or Older. Office of Retirement and Disability Policy and Office of Research, Evaluation, and Statistics. Washington, DC, April 2010. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office, 2011. Williams, C. Arthur, Jr., John G. Turnbull, and Earl F. Cheit. Economic and Social Security. 5th ed. New York: John Wiley & Sons, 1982. Chapter 2. U.S. Census Bureau. Income, Poverty, and Health Insurance Coverage in the United States: 2010. Washington, DC, September 2011. Vanderhei, Jack, Employee Benefit Research Institute. “Retirement Income Adequacy for Today’s Workers: How Certain, How Much Will It Cost, and How Does Eligibility for Participation in a Defined Contribution Plan Help?” EBRI Notes 31, no. 9, September 2010.

Notes 1. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2011), Table V.A2, p. 88. 2. U.S. Census Bureau, Statistical Abstract of the United States: 2011 (130th Edition) (Washington, DC, 2010), Table 585. 3. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, Table V.A3, p. 90. 4. Statistical Abstract of the United States: 2011, Table 585. 5. Employee Benefit Research Institute, “Executive Summary: Employment Status of Workers Ages 55 or Older, 1987–2008.” Notes 31, no. 3 (March 2010), Figure 1. 6. With the exception of the measures of poverty and family income of persons, an aged unit is a married couple living together or a person who does not live with a spouse. The unit of analysis for family income of persons and poverty is persons aged 65 or older. 7. Social Security Administration, Income of the Aged Chartbook, 2008, Office of Retirement and Disability Policy and Office of Research, Evaluation, and Statistics (Washington, DC, April 2010), p. 9. 8. Employee Benefit Research Institute, “The 2010 Retirement Confidence Survey: Confidence Stabilizing, But Preparations Continue to Erode.” Issue Brief no. 240, March 2010, p. 17. 9. Ibid. 10. U.S. Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2010 (Washington, DC, September 2011), p. 14. The supplemental poverty measure is discussed in U.S. Census Bureau, “The Research Supplemental Poverty Measure: 2010,” Current Population Reports, P60-241, November 2011.

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11. Virginia P. Reno and Joni Lavery, Fixing Social Security: Adequate Benefits, Adequate Financing (Washington, DC: 2009), p. 9. 12. Medicare.gov at www.medicare.gov/LongTermCare/Static/Home.asp 13. Elder Abuse and Neglect: Warnings Signs, Risk Factors, Prevention, and Help. Available at Helpguide.org, modified February 8, 2010. 14. National Academy of Social Insurance, Social Security: An Essential Asset and Insurance Protection for All. Social Security Brief no. 26, February 2008. 15. U.S. Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2010 (Washington, DC, September 2011), Table 4, p. 15, p. 22. 16. Bureau of Labor Statistics, “Employee Benefits in the United States March 2010.” News release, July 27, 2010, Table 1. 17. Employee Benefits Research Institute, EBRI Data Book on Employee Benefits, Chapter 8, Tables 8.1 and 8.2, updated September 2009. 18. Employee Benefit Research Institute, “Executive Summary: Lump Sum Distributions at Job Change.” Notes 30, no. 1 (January 2009). 19. Employee Benefit Research Institute, “The Impact of the Recent Financial Crisis on 401(k) Account Balances.” EBRI Issue Brief no. 326 (February 2009). 20. This section is based on U.S. Department of Housing and Urban Development, Homes and Communities, Home Equity Conversion Mortgages for Seniors, January 27, 2009. 21. Kelly Greene and Anne Tergesen, “Reverse Mortgages Now Look Cheaper.” Wall Street Journal, April 17, 2010. 22. Ibid.

5 Old-Age, Survivors, and Disability Insurance

Student Learning Objectives After studying this chapter, you should be able to: • Explain the meaning of fully insured, currently insured, and disability insured. • Explain the meaning of primary insurance amount (PIA). • Understand how Social Security benefits are calculated. • Describe the retirement, survivor, and disability benefits under the Social Security program. • Explain the situations that can result in a reduction or loss of monthly cash ­benefits. • Explain how the Social Security program is financed. The Old-Age, Survivors, and Disability Insurance (OASDI) program is the most important public program in the United States for reducing economic insecurity from premature death and old age. In the United States, the OASDI program is also called Social Security. Most workers today work in jobs covered by the OASDI program. In this chapter, we discuss the major provisions of the current OASDI program.1 Topics discussed include the historical development of the Social Security Act, and key provisions of the program, including coverage, insured status, benefits, loss or reduction of benefits, and the taxation of benefits. The chapter concludes with a discussion of financing and administration.

Development of the Social Security Act Changing Structure of the Economy The present program had its genesis in the Social Security Act of 1935.2 Passage of the act was partly a response to changing social and economic conditions in the United States prior to 1935. 97

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Before 1870, the United States was predominantly an agricultural economy, which made it possible for many workers to become financially self-sufficient and provide for their own economic security. A rapidly growing population, an abundance of natural resources, and an open frontier provided economic opportunities to workers and their families. However, the change from a predominantly rural to a highly industrialized economy created new risks for the workers and threatened their economic security. Workers became dependent on earned income and jobs in the labor markets, and any event that resulted in the loss or reduction of their earned incomes, such as old age, unemployment, job-related injuries, or sickness, could lead to economic insecurity. Workers were no longer financially self-sufficient, but had to depend on a growing economy for jobs and their economic security. During the early development of the United States, many cities and towns provided some type of financial assistance to poor individuals and families. The aid often consisted of the poor relief system and almshouses and, in many cases, the aid was grudgingly given. As the economy continued to expand, many states enacted laws that provided some type of financial assistance to widows and orphans. In the 1920s, a few states also provided financial help to the poor under old-age assistance programs and programs to aid the blind. After 1900, both the federal government and the states began to enact workers’ compensation laws that covered job-related injuries to covered workers. By 1929, most states had enacted workers’ compensation laws. Finally, retirement programs for teachers, police, and firefighters were also established. The enactment of social insurance programs in the United States, however, lagged behind the development of social insurance in foreign nations. Germany established an old-age pension program in 1889 and Great Britain did so in 1909. However, the United States did not enact federal pensions for anyone except for military personnel until 1935. The slower development can be explained by the emphasis on rugged individualism, the unconstitutionality of some early social insurance laws, the relatively high wages paid before the depression of the 1930s, and lack of strong support by some labor unions.

The Great Depression The Great Depression of the 1930s highlighted the need for massive federal action to meet the problem of economic insecurity from old age, unemployment, premature death, and disability. Massive unemployment, hunger, poverty, and wasted human resources resulted in enormous human suffering and highlighted the need for corrective federal legislation to reduce economic insecurity from the severe depression. The Townsend Plan, proposed in 1934, also focused attention on the need for corrective action. Under the plan, each citizen age 60 or over would receive a monthly pension of $200, which had to be spent within 30 days, and the recipient could not engage in any employment. The Townsend Plan was never enacted, however, primarily because of financing concerns about the incidence of the tax, possible inflationary effects, and the view that $200 was a relatively high benefit compared with prevailing wage levels.

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Enactment of the Social Security Act President Franklin D. Roosevelt created the Committee on Economic Security in 1934 to study the problem of economic insecurity and make suggestions for legislation. The committee’s report, submitted in 1935, became the basis of the Social Security Act, which was enacted on August 14, 1935. The act provided for a compulsory federal program of old-age benefits for workers in industry and commerce; a federal-state program of unemployment insurance; and federal grants-in-aid to the states for old-age assistance, aid to the blind, and aid to dependent children. In addition, the act established federal grants to the states for maternal and child health services, services for disabled children, public health services, and vocational rehabilitation. The original Social Security Act of 1935 provided retirement benefits at age 65 for most workers in industry and commerce. Payment of payroll taxes started in 1937, and benefits were scheduled to start in 1942. This delay was viewed as a type of vesting period in which a certain amount of work would be required to qualify for benefits. In addition, the delay in the payment of benefits allowed time to build up some financial reserves before payments were first paid to beneficiaries. Since its enactment in 1935, the Social Security program has been changed and liberalized several times. In 1939, survivor benefits were added. In the 1950s, coverage was broadened to include most self-employed persons; household and farm employees; members of the armed services; ministers; most employees of charitable, educational, and religious nonprofit organizations; and the majority of state and local government employees. In 1956, disability insurance was added to cover the loss of earnings from total disability. In 1965, the Medicare program was enacted to provide hospital insurance and medical insurance for the aged. In 1972, the Social Security Act was amended to automatically increase benefits based on measurable changes in the Consumer Price Index and also extended the Medicare program to disabled beneficiaries who had been on the rolls for at least 24 months. In 1977, tax contributions were substantially increased, and the method for computing monthly cash benefits was also changed. In addition, based on the recommendations of the National Commission on Social Security Reform (also known as the Greenspan Commission), sweeping legislative changes were made in the Social Security program in 1983; the changes in the law were designed to restore financial stability to the Social Security program both in the short run and the long-term future. The 1983 legislation provided for numerous changes, including mandatory coverage of newly hired federal employees, acceleration of scheduled tax rate increases, income taxation of part of the benefits for upperincome persons, and a higher normal retirement age (now called a full retirement age) that will gradually increase to age 67 under present law. Finally, the Medicare Catastrophic Coverage Act of 1988 was enacted into law to cover catastrophic medical expenses incurred by the elderly. The act was repealed a year later. Since that time, numerous changes in the total program have been made.

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Covered Occupations Employees in Private Firms The Social Security program is a compulsory program that covers virtually all gainfully employed workers in private firms. As a result, the workers are building valuable protection against the loss or reduction of earnings because of retirement, disability, or death.

Federal Civilian Employees All civilian employees of the federal government hired after 1983 are covered on a compulsory basis. This includes federal employees in the Federal Employees Retirement System. Federal civilian employees hired before 1984 are covered under the Civil Service Retirement System and are not required to contribute to the OASDI program but must contribute to the Hospital Insurance (HI) portion of the Medicare program. The OASDI program also covers the president, vice-president, and current and future members of Congress.

Employees of Religious, Charitable, and Educational Nonprofit Organizations Employees of religious, charitable, and educational nonprofit organizations are covered on a compulsory basis if they are paid $100 or more in a year. However, church organizations that object to the payment of Social Security taxes based on religious principles can irrevocably elect not to be covered. In such a case, the employees are considered to be self-employed and must pay self-employment taxes on their earnings.

State and Local Government Employees State and local government employees can be covered by a voluntary agreement between the state and federal government. In addition, if the employees are covered under an existing retirement plan, the majority of them must agree to be covered under Social Security. However, state and local government employees hired after March 1986 are compulsorily required to pay the HI tax under the Medicare program. In addition, all state and local government employees in a public employee retirement plan are covered under OASDI and the HI portion of Medicare on a compulsory basis. About one-fourth of public employees are not covered for Social Security benefits.3

Self-Employed Self-employed workers are covered on a compulsory basis if their net profits are at least $400 during the year. This includes self-employed professionals, such as physicians, dentists, and attorneys.

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Farm Operators and Farm Workers Self-employed farmers are covered if their net annual earnings are at least $400. There is an alternate reporting system based on gross income for low-income farmers. A farm worker is covered if (1) he or she earns $150 or more in cash wages during the calendar year for farm work, or (2) earns less than $150 in cash wages, and the employer spends $2,500 or more annually on agricultural labor. However, a different rule applies to seasonal hand-harvest workers who commute to work daily from their homes, are paid on a piece-rate basis, and have worked fewer than 13 weeks in farm work during the previous year. A worker must be covered if the employer pays at least $150 in cash for the job.

Employees Receiving Tips The tip income of employees receiving cash tips of $20 or more in a month from one employer is also covered. The employee must pay a Social Security tax on them, and the employer must also pay a matching tax contribution on the tips.

Ministers Ministers are automatically covered unless they elect out because of conscience or religious principles. Although ministers may be working as employees, they report their income and pay Social Security tax contributions as if they were self-employed. Members of a religious order who have taken a vow of poverty can also be covered under the Social Security program if the order elects to cover them on an employeremployee basis.

Railroad Employees Railroad workers subject to the Railroad Retirement Act are not required to pay Social Security taxes. However, because of certain coordinating provisions, railroad employees can obtain coverage under the Social Security program under certain conditions. These provisions are discussed later in Chapter 17.

Foreign Employment If an employee works overseas for an American company or, in some cases, a foreign company that is affiliated with an American company, both the employee and employer may have to pay Social Security taxes to the United States as well as to the foreign country on the same earned income. However, the United States has entered into international agreements with many foreign countries to avoid double taxation while working abroad. If the employee works in one of the agreement countries, his or her Social Security coverage will be assigned to either the United States or to the foreign country, so that double taxation is avoided. If you have been sent by your employer in the United States to work in an agree-

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ment country for five years or less, you pay only U.S. Social Security taxes and are exempt from foreign taxes. However, if the employee is hired in one of the agreement countries or sent to that country for more than five years, he or she will generally pay Social Security taxes only to that country and will be exempt from paying U.S. Social Security taxes.

Excluded Occupations Approximately 94 percent of the U.S. labor force is covered by the Social Security program. Workers excluded from coverage fall into the following categories: • Civilian federal employees hired before January 1, 1984 • Railroad workers covered under the Railroad Retirement System, which is coordinated with Social Security • Certain state and local government employees who are covered under their employers’ retirement systems • Domestic workers and farm workers whose earnings are below certain minimum requirements (workers in industry and commerce are covered regardless of the amount of earnings) • Workers with very low net earnings from self-employment, generally under $400 annually

Determination of Insured Status Before benefits can be paid, workers must have credit for a certain amount of work in covered employment. For 2011, covered employees and the self- employed received one credit (also called a quarter of coverage) for each $1,120 in covered annual earnings. A maximum of four credits can be earned during the year. The amount of covered earnings needed for a quarter of coverage will automatically increase in the future as average wages increase. To become eligible for the various benefits, workers must attain an insured ­status. There are three principal types of insured status: • Fully insured • Currently insured • Disability insured Retirement benefits require a fully insured status. Survivor benefits require either a fully insured or currently insured status; however, certain types of survivor benefits require a fully insured status. Disability benefits require a disability insured status.

Fully Insured You are fully insured for retirement benefits if you have 40 credits or 10 years of work. After you attain 40 quarters of coverage, you are permanently insured for life even if you withdraw from the labor force. However, for people born before 1929 fewer credits are needed.

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Status  103

Currently Insured A currently insured status is easy to attain. You are currently insured if you have at least 6 credits out of the last 13 quarters ending with the quarter of death, disability, or entitlement to retirement benefits.

Disability Insured Social Security pays disability benefits to people who cannot work because they have a medical condition that is expected to last at least one year or result in death. Social Security benefits are not paid for partial disabilities or short-term disabilities. To be eligible to receive disability benefits, you must generally meet two tests: (1) the recent work test based on your age at the time you became disabled, and (2) the duration of work test to show that you worked long enough under Social Security to qualify for benefits.4 Certain blind workers are treated more generously and have to meet only the duration of work test. Recent Work Test. The number of credits needed to meet the recent work test requirement depends on your age when you became disabled. The following rules apply:5 • If you become disabled in or before the quarter you turn age 24, you need 1.5 years of work (6 credits) during the 3-year period ending with the quarter your disability began. • If you become disabled in the quarter after you turn age 24 but before the quarter in which you turn age 31, you need credits equal to half of the time between age 21 and the time you became disabled. For example, if you become disabled in the quarter you turned age 27, you would need 3 years of work out of the past 6 years ending with the quarter in which you became disabled. • If you become disabled in the quarter you turn age 31 or later, you need 5 years of work years out of the 10-year period ending with the quarter your disability began. Duration-of-Work Test. The following table by the Social Security Administration shows examples of how much work is needed to meet the duration-of-work test if you become disabled at various selected ages.6 To meet the duration-of-work test, your work does not have to occur within a certain period of time. If you become disabled: Before age 28 Age 30 Age 34 Age 38 Age 42 Age 44

Then you generally need: 1.5 years of work 2 years 3 years 4 years 5 years 5.5 years

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If you become disabled: Age 46 Age 48 Age 50 Age 52 Age 54 Age 56 Age 58 Age 60

Then you generally need: 6 years 6.5 years 7 years 7.5 years 8 years 8.5 years 9 years 9.5 years

Benefit Amounts The benefit amounts depend on the worker’s primary insurance amount, average monthly indexed earnings, and any credits for delayed retirement. In addition, OASDI benefits are automatically adjusted each year for inflation based on measurable changes in the consumer price index, which protects the purchasing power of the benefits paid.

Primary Insurance Amount Monthly retirement benefits are based on the worker’s primary insurance amount (PIA). The PIA is the monthly amount paid to a retired worker at the full retirement age or to a disabled worker. It is based on the worker’s average indexed monthly earnings (AIME), which is a method that updates the worker’s earnings based on increases in the average wage in the national economy. The indexation method ensures that a worker’s future benefits reflect the general rise in the standard of living that occurred during the worker’s lifetime.

Average Indexed Monthly Earnings (AIME) Earnings are indexed or adjusted to take into account changes in average wages in the economy since the worker received the earnings. The indexing year is the second year before the year in which the worker attains age 62 or, if earlier, becomes disabled or dies. Earnings for and after the indexing year are counted in actual dollar amounts. For example, assume that Joseph retired at age 62 in 2011. The significant year for setting the index factor is the second year before he attained age 62 (2009). Assume that Joseph’s actual earnings in 1971 were $6,075. If Joseph’s actual earnings ($6,075) are multiplied by the index factor for 1971 (6.2661), his indexed earnings are $38,067 for 1971. This procedure is carried out for each year in the measuring period except that earnings for and after the indexing year are counted in actual dollar amounts. The resulting average amount from the application of this method is then rounded down to the next dollar amount. The result is the AIME. The AIME is then used to determine the worker’s primary insurance amount. The index factors change each year as average wages in the national economy change.

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For workers born after 1928, the highest 35 years of indexed earnings are used to calculate the worker’s AIME for retirement benefits. A weighted benefit formula is used, which weights the benefits heavily in favor of lower-income groups. This weighting reflects the social adequacy principle discussed in Chapter 2.

Primary Insurance Amount Formula As stated above, after the worker’s AIME is computed, a weighted formula is used to determine the primary insurance amount (PIA). The PIA is the sum of three separate percentages of the worker’s AIME. These percentages depend on the year the worker attains age 62, becomes disabled before age 62, or dies before attaining age 62. For workers who first become eligible for retirement benefits or disability insurance benefits in 2011, or who die in 2011 before becoming eligible for benefits, their PIA is the sum of the following: 90 percent of the first $749 of AIME + 32 percent of AIME over $749 and through $4,517 + 15 percent of AIME over $4,517 This amount is then rounded to the next lower multiple of $.10 if it is not already a multiple of $.10. For example, assume that Joseph had maximum taxable earnings each year from age 22 and retired at age 62 in 2011. He would have an AIME equal to $7,928. Based on this AIME amount and bend points (dollar amounts) of $749 and $4,517, respectively, Joseph would have a PIA of $2,391.50. He would receive a reduced monthly benefit based on the PIA of $2,391.50 7 The formula is adjusted annually for new cohorts. The bend points in the formula are adjusted each year to reflect changes in average wages in the national economy. In addition, the benefit amount resulting from application of the formula is subject to the automatic cost-of-living provisions for the year of attainment of age 62 (or prior death or disability) and after. The benefit formula weights the benefits heavily in favor of low-income persons. As stated earlier, this is a reflection of the social adequacy principle discussed earlier in Chapter 2. The formula also reflects the principle of relating monthly cash benefits to the worker’s earnings. As the worker’s average indexed monthly earnings increase, the primary insurance amount also increases, but not proportionately to the increase in earnings. For example, assume that in 2010, a worker retires at the full retirement age of 66. The percentage of career-average earnings replaced by Social Security benefits would be 56.3 percent for low earners, 41.7 percent for medium earners, 34.6 percent for high earners, and 28.3 percent for steady maximum earners. This can be illustrated by the following:8

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Retirement Benefits at Full Retirement Age Career Average Earnings Low earners Medium earners High earners Maximum earners

Retirement Age (66)

Percentage of Earnings Replaced

$10,729 17,676 23,430 27,955

56.3 41.7 34.6 28.3

In 2010, the national average wage index (AWI) was $43,084. The low earner is a worker who earned about 45 percent of the Social Security average wage index. The average earner is a worker who earned about 100 percent of the Social Security averagewage index. The high earner is a worker who earned about 160 percent of the average wage index. The maximum earner is a worker who has annual earnings equal to the maximum Social Security taxable wage and contribution base ($106,800 in 2010).

Automatic Cost-of-Living Adjustment The monthly cash benefits are automatically adjusted each year for measurable increases in the cost of living, which maintains the real purchasing power of the benefits. Whenever the Consumer Price Index for all urban wage earners and clerical workers (CPI-W) on a quarterly basis increases from the third quarter of the previous year to the third quarter of the present year, the benefits are automatically increased by the same percentage. The benefit increase applies to the December benefit that is payable in January. For example, the January 2009 benefit payments reflected a 2.1 percent increase based on the cost-of-living provision. There was no increase in benefits for 2010 and 2011. If the increase in the CPI-W during the measurement period is at least one-tenth of one per­cent (0.1 percent), a costof-living adjustment (COLA) is paid. However, if the CPI-W increase is less than 0.05 percent, or if the CPI-W decreases, a COLA is not paid. The Bureau of Labor Statistics determined there was no increase in the CPI-W from the third quarter of 2008, the last year a COLA was determined, to the third quarter of 2010. Therefore, a COLA was not paid for 2010 and 2011.

Delayed Retirement Credit To encourage working beyond the full retirement age, a delayed retirement credit is available. The PIA is increased by a certain percentage from the time the worker reaches the full retirement age until the worker starts to receive benefits, or until age 70, if the worker delays retirement until that time. The percentage increase in benefits depends on the worker’s date of birth. For example, for workers born in 1943 or later, the PIA is increased 8 percent for each year (prorated monthly) of delay beyond the full retirement age.

Maximum Family Benefits There is a maximum limit on the monthly benefits that can be paid to the family based on the earnings record of one person. Maximum family benefits are based

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on the worker’s primary insurance amount and are generally higher for retirement and survivor benefits than for disability benefits. The maximum family benefit for persons who attain age 62 in 2011 or die in 2011 before attaining age 62 is based on the following formula: 150 percent of the first $957 of the worker’s PIA + 272 percent of the worker’s PIA over $957 through $1,382 + 134 percent of the worker’s PIA over $1,382 through $1,803 + 175 percent of the worker’s PIA over $1,803 For disabled persons, the maximum family benefit is 85 percent of the worker’s AIME. However, the maximum benefit cannot be less than the worker’s primary insurance amount or more than 150 percent of the primary insurance amount. Whenever the total monthly benefits payable to all beneficiaries on the basis of one earnings record exceed the maximum allowed, each dependent’s or survivor’s benefit is proportionately reduced (but not the worker’s benefit) to bring the total within the maximum.

Types of Benefits The total Social Security program provides the following four benefits: • Retirement benefits • Survivor benefits • Disability benefits • Medicare benefits In this chapter, we discuss only retirement, survivor, and disability benefits. The Medicare program is discussed in Chapter 10.

Retirement Benefits Retirement benefits provide an important layer of income protection to retired workers and their families. Without these benefits, economic insecurity for the aged would be substantially increased. Full Retirement Age

The full retirement age (also called the normal retirement age) is the age at which full, unreduced benefits are paid. For people born in 1937 or earlier, the full retirement age for unreduced benefits is age 65. For people born in 1943 through 1954, the full retirement age is 66. The full retirement age will increase to age 67 for people born in 1960 or later.

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Early Retirement Age

Workers and their spouses can elect to retire early, at age 62, with actuarially reduced benefits. The majority of beneficiaries currently are retiring before the full retirement age. However, the benefits are actuarially reduced for early retirement because of the longer duration of payments. The actuarial reduction in benefits for early retirement at age 62 will gradually increase to 30 percent in the future, when the higher full retirement age provisions become effective. Table 5.1 shows the future increases in the full retirement age and the actuarial reductions for early retirement. If a person retires early and works after retiring, and benefits are withheld because of the earnings test (discussed later), the benefits are automatically recomputed at the full retirement age in recognition of the period when there were earnings. Retired Worker

A fully insured retired worker can receive a monthly benefit equal to the primary insurance amount at the full retirement age. Reduced benefits can be paid as early as age 62.

Table 5.1

Primary and Spousal Benefits at Age 62 (benefits based on a $1,000 primary insurance amount)

Year of Birtha 1937 or earlier

1938 1939 1940 1941 1942 1943–1954 1955 1956 1957 1958 1959 1960 and later a

Normal (or full) retirement age 65 65 and 2 months 65 and 4 months 65 and 6 months 65 and 8 months 65 and 10 months 66 66 and 2 months 66 and 4 months 66 and 6 months 66 and 8 months 66 and 10 months

67

Primary

Spouse

Number of reduction monthsb

Amount

Percent Reductionc

Amount

Percent Reductiond

36 38 40 42 44 46 48 50 52 54 56 58

$800 791 783 775 766 758 750 741 733 725 716 708

20.00 20.83 21.67 22.50 23.33 24.17 25.00 25.83 26.67 27.50 28.33 29.17

$375 370 366 362 358 354 350 345 341 337 333 329

25.00 25.83 26.67 27.50 28.33 29.17 30.00 30.83 31.67 32.50 33.33 34.17

60

700

30.00

325

35.00

If you are born on January 1, use the prior year of birth. Applies only if you are born on the 2nd of the month; otherwise the number of reduction months is one less than the number shown. c Reduction applied to primary insurance amount ($1,000 in this example). The percentage reduction is 5/9 of 1% per month for the first 36 months and 5/12 of 1% for each additional month. d Reduction applied to $500, which is 50% of the primary insurance amount in this example. The percentage reduction is 25/36 of 1% per month for the first 36 months and 5/12 of 1% for each additional month. Source: Social Security Administration. b

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Spouse of Retired Worker

The spouse of a retired worker can receive benefits based on the worker’s earnings if the spouse is at least age 62. A divorced spouse is also eligible for benefits based on the worker’s earnings if the spouse is at least age 62, unmarried, and the marriage lasted at least 10 years. In addition, if the worker and ex-spouse have been divorced for at least two years, and both are at least age 62, the ex-spouse can receive benefits even though the worker has not yet retired. The amount of benefits that a divorced spouse receives does not affect the amount of benefits that a retired worker or current spouse can receive. A spouse who has worked may be eligible for retirement benefits based on his or her own earnings and the retired worker’s earnings. However, two full benefits are not paid. If the spouse is eligible for benefits based on both the spouse’s earnings and the worker’s earnings, the spouse’s benefits are paid first. If the benefits as a spouse are higher than the benefits based on the worker’s earnings, the spouse’s benefit is paid first. The spouse will then be paid an additional amount so that the combination of both benefits will equal the higher spouse’s benefit. The spouse’s benefit at the full retirement age is equal to 50 percent of the retired worker’s PIA. If a spouse receives benefits before the full retirement age, the benefit amount is reduced. The percentage reduction in benefits depends on when the spouse reaches the full retirement age. The following are examples of the possible reduction in the benefits payable to a spouse before the full retirement age: • If the full retirement age is 65, a spouse can receive 37.5 percent of the worker’s unreduced benefit at age 62; • If the full retirement age is 66, a spouse can receive 35 percent of the worker’s unreduced benefit at age 62; • If the full retirement age is 67, a spouse can receive 32.5 percent of the worker’s unreduced benefit at age 62. The amount of the benefit increases at the later ages up to the maximum of 50 percent at the full retirement age. If full retirement age is other than those shown above, the benefit amount will fall between 32.5 percent and 37.5 percent at age 62. Unmarried Children Under Age 18

Monthly benefits can also be paid to unmarried children of a retired worker who are under age 18 (or under 19 if full-time elementary or high school students). The monthly benefit to each child is 50 percent of the PIA. Unmarried Disabled Children

Unmarried disabled children age 18 or over are eligible for benefits based on the retired worker’s earnings if they were severely disabled before age 22 and continue to remain disabled. The benefit is 50 percent of the PIA.

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A spouse at any age can receive a benefit equal to 50 percent of the PIA if he or she is caring for an eligible child under age 16 (or is caring for a child of any age who was disabled before age 22) who is receiving a benefit based on the retired worker’s earnings. The mother’s or father’s benefit terminates when the youngest child reaches age 16 (unless he or she is caring for a disabled child who became disabled before age 22).

Survivor Benefits A second benefit is the payment of monthly survivor benefits to surviving family members after a worker dies. The benefits provide substantial protection against economic insecurity due to premature death. For example, assume that a worker, age 30, has a spouse, age 28, a child, age 2, and an infant under age one. The value of Social Security survivor benefits in terms of private life insurance equivalents is $433,000.9 The benefits, however, are paid monthly and not in a lump sum. Unmarried Children Under Age 18

Survivor benefits can be paid to unmarried children under age 18 (or under 19 if fulltime elementary or high school students). The deceased parent must be either fully or currently insured. The benefit for each child is 75 percent of the deceased’s PIA. In addition, grandchildren may be eligible for benefits based on a grandparent’s earnings if the requirements described earlier in the case of retirement benefits are met. Children Disabled Before Age 22

Children at any age who were disabled before age 22 and remain disabled are eligible for survivor benefits based on the deceased worker’s earnings. The benefit is 75 percent of the PIA. The deceased worker must be either currently insured or fully insured for a child’s benefit to be payable and for the lump-sum death benefit. A fully insured status is required for all other survivor benefits. Surviving Spouse with Children Under Age 16

A widow, widower, or surviving divorced mother or father is entitled to monthly benefits if he or she is caring for an eligible child under age 16 (or disabled before age 22) who is receiving a benefit based on the deceased worker’s earnings. The deceased must be either fully or currently insured. The monthly benefit is 75 percent of the PIA, and it is paid until the youngest child reaches age 16 (unless the parent is caring for a disabled child). Surviving Spouse Age 60 or Over

A surviving spouse age 60 or over is also eligible for survivor benefits. The deceased must be fully insured. The monthly benefit payable at full retirement age is generally 100 percent of the PIA. Reduced benefits can be paid as early as age 60.

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A surviving divorced spouse age 60 or older is also eligible for survivor benefits if the marriage lasted at least 10 years. However, the divorced spouse does not have to meet the age or length-of-marriage rule if the spouse is caring for a child under age 16 or who is disabled and also entitled to benefits. Disabled Widow or Widower, Ages 50–59

A disabled widow or widower may be eligible to receive survivor benefits at age 50 under certain conditions. First, the disabled person must meet the Social Security disability requirements (covered later). Second, the disability must begin before age 60 and within 7 years of the latest of the following: (1) the month the worker died, (2) the last month the disabled person was entitled to the mother’s or father’s benefits based on the worker’s record, or (3) the month the disabled person’s previous entitlement to disability benefits ended because the disability ended. Dependent Parents

A parent is entitled to survivor benefits based on the wage record of a deceased child if the child is fully insured, and the parent is age 62 or older, is not entitled to benefits based on his or her own record that are equal to or greater than the amount of the survivor’s benefits, and is receiving at least one-half support from the deceased child. Lump-Sum Death Benefit

A lump-sum death benefit of $255 can be paid only to an eligible spouse or minor children who meet certain requirements. First, the benefit is paid to a surviving spouse who is living in the same household with the worker when he or she dies. Second, if there is no eligible spouse to receive the payment, the lump sum is paid to the deceased worker’s child (or children) who are receiving benefits based on the deceased worker’s earnings record during the month in which the worker dies, or is eligible to receive benefits.

Disability Benefits The third benefit is the payment of disability benefits to eligible disabled workers. In some cases, the disability occurs suddenly without warning, such as a worker who is paralyzed for life in a severe auto accident while driving to work. In other cases, the disability may extend over several months or even longer before the individual dies, such as a worker with cancer of the pancreas. Relatively few workers have sufficient financial resources on which to draw during a period of long-term disability. In recognition of the crushing financial impact from a long-term disability, disability benefits were first added to the program in 1956. The value of disability benefits is substantial. According to the National Academy of Social Insurance, the disability benefits are the equivalent of a $414,000 disability

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income policy purchased in 2006. That amount represents the total benefits available to a worker, age 30, who becomes disabled after earning between $25,000 and $30,000 annually, and who has a spouse age 28, a child age 2, and an infant under age one.10 Eligibility Requirements

To be eligible for benefits, a disabled worker must meet the following eligibility requirements: • Be disability insured • Meet the definition of disability stated in the law • Fulfill a full five-month waiting period   Be Disability Insured  To be eligible for disability benefits, the disabled worker must be disability insured. The meaning of disability insured has already been discussed, so additional treatment is not necessary here.   Meet the Definition of Disability  A strict definition of disability is used in the OASDI program. Disability is defined as the inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment(s), which can be expected to result in death or has lasted or is expected to last for a continuous period of at least 12 months. The impairment must be so severe that the worker is unable to perform his or her previous work and cannot, considering the worker’s age, education, and work experience, engage in any substantial gainful work that exists in the national economy. Work does not have to be full time to be considered substantial; part-time work can also be considered substantial. A job does not have to exist in the immediate area where the disabled worker resides, nor does a specific job vacancy have to exist. The worker does not have to be assured of being hired if he or she applies for the job. Jobs must exist, however, in significant numbers, in the region where the worker resides or in several regions of the country. Finally, if the worker earns more than $1,000 monthly in 2011 ($1,640 if blind), the worker is considered as engaging in substantial gainful activity and therefore not considered disabled. In addition, special provisions apply to the blind. A person with eyesight impairment may qualify for Social Security benefits if he or she is legally blind. A person is considered legally blind if his or her vision cannot be corrected to 20/200 in the better eye, or if the field of vision is 20 degrees or less in the better eye. If the applicant’s vision does not meet the legal definition of blindness, he or she may still qualify for disability benefits if vision problems alone or, when combined with other health problems, prevent the person from working. However, the applicant must have worked long enough in a job where he or she paid Social Security taxes. If the worker is legally blind, he or she can earn credits anytime during the working career to qualify for benefits. Credits for work after blindness occurs can also be used

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to qualify the worker for benefits if the worker does not have a sufficient number of credits at the time of blindness. The special provisions also include work incentives that apply to blind people. They include the following: • Average monthly earnings of $1,640 or less in 2011 are not considered substantial gainful work. This amount is substantially higher than the $1,000 monthly limit that applies to disabled workers who are not blind. The limitation on earnings is typically increased each year. • If a legally blind person is age 55 or older, the ability to work is considered differently than for people who are not blind. A blind person age 55 or older is considered disabled if he or she cannot perform work requiring skills or abilities comparable to those required by the work the person did regularly in the past. This definition of disability is more liberal than that for younger blind persons. • If the worker’s earnings are too high to receive disability income benefits, he or she may be eligible for a disability “freeze.” This means that future benefits, which are based on average earnings, will not be reduced because of relatively lower earnings in those years in which the worker is blind.   Five-Month Waiting Period  The disabled worker must also meet a five-month waiting period. Benefits begin after a waiting period of five full calendar months. Therefore, the first payment is for the sixth full month of disability, payable in the seventh month.

Groups Eligible for Disability Income Benefits Major groups who are eligible to receive OASDI disability income payments include the following: • Disabled Worker. A disabled worker under the full retirement age can receive a benefit equal to 100 percent of the primary insurance amount. The worker must be disability insured, meet the definition of disability, and satisfy a five-month waiting period. • Spouse of Disabled Worker. The spouse of a disabled worker at any age can receive benefits if he or she is caring for a child who is under age 16 or who became disabled before age 22 and is receiving benefits based on the disabled worker’s record. If there are no eligible children, the spouse must be at least age 62 to receive benefits. • Unmarried Children. Unmarried children under age 18 (or under age 19 if a fulltime student in an elementary or secondary school) are also eligible for benefits based on the disabled worker’s earnings. • Person Disabled Before Age 22. A person who becomes disabled before age 22 can receive disability benefits if one of the parents is entitled to retirement or

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disability benefits or dies after being covered for a sufficient length of time under the OASDI program. A person disabled before age 22 does not need OASDI work credits to receive benefits. The payments are based on the parent’s earnings and continue for as long as the child remains disabled and unmarried, and the parent’s eligibility continues. • Divorced Spouse. In some situations, a divorced spouse may qualify for benefits based on the disabled worker’s earnings if he or she was married to the worker for at least 10 years, is not currently married, and is at least age 62. As stated earlier, the benefits paid to a divorced spouse do not reduce the worker’s benefit or any benefits payable to the worker’s current spouse or children.

Offset for Other Disability Payments If a disabled person is also receiving workers’ compensation benefits for a job-related injury or disease, or is receiving disability payments from certain federal, state, or local government plans, the maximum monthly benefit to the worker or family is limited to 80 percent of the worker’s average current earnings. Private insurance benefits, however, are not counted under this provision.

Medicare Benefits Disabled individuals under age 65 who have been receiving Social Security or Railroad Retirement disability benefits for at least 24 months are eligible for Medicare Part A (Hospital Insurance) coverage. Most people under age 65 who have end-stage renal disease or kidney failure are also eligible for Medicare Part A. The 24-month waiting period is waived for disabled individuals with Lou Gehrig’s disease (amyotrophic lateral sclerosis).

Work Incentives Some disabled workers are capable of returning to productive employment. The disability income program has several incentives to encourage work. They are summarized as follows:11 • Trial Work Period. Benefits are paid during a nine-month trial work period. Full Social Security benefits are paid regardless of total earnings as long as the earnings are reported and the impairment continues. The purpose of the trial period is to determine if the disabled worker is capable of working. In 2011, a trial work month is any month in which total earnings exceed $720, or if the worker is self-employed, he or she earns more than $720 (after expenses), or spends more than 80 hours working in the business. The months in the trial work period do not have to be consecutive. The trial work period continues until the disabled worker has worked 9 months within a 60-month period. • Extended Period of Eligibility. After the trial work period ends, the disabled worker has 36 months during which he or she can work and still receive benefits

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for any month that earnings are not considered “substantial.” In 2011, earnings over $1,000 monthly ($1,640 if blind) were considered substantial. A new application or disability decision is not required to receive a Social Security disability benefit during this period. • Expedited Reinstatement. If the benefits stop because earnings are substantial, the worker has five years during which he or she can request that the benefits start immediately because of his or her medical condition. A new disability application is not required, and the worker does not have to wait for the benefits to start while the medical condition is being reviewed. • Work-Related Expenses. Certain impairment-related work expenses can be deducted from earnings for the purpose of determining whether the worker is performing substantial gainful work. Items that are generally deductible include medical devices and equipment (such as a wheelchair), attendant care, and drugs and services required because of the impairment. • Continuation of Medicare. If benefits terminate because of earnings, and the worker is still disabled, the Medicare Part A coverage will still continue for at least 93 months after the 9-month trial work period ends. After that time, the disabled worker must pay a monthly premium to retain Medicare Part A coverage. If the worker has Medicare Part B coverage, he or she must continue to pay the premium. • Ticket to Work. Under this program, Social Security disability beneficiaries receive help with training and other services to go to work at no cost to them. Most beneficiaries will receive a “ticket” that they can take to a provider of their choice who can offer the types of services they need, such as finding a job, vocational rehabilitation, or other employment services. Providers are employment organizations or state vocational agencies that help disabled workers find jobs, or provide vocational rehabilitation or other services at no cost. The disabled worker has the opportunity to choose from among a variety of employment networks.

Disability Freeze A disability freeze means that periods of disability can be excluded for purposes of determining insured status and average indexed monthly earnings. To qualify for the disability freeze, the worker must be disability insured and also meet the definition of disability for the monthly cash benefits. The purposes of the disability freeze are to prevent workers from losing their insured status during a period of disability or from having future retirement or disability benefits reduced because of little or no earnings during the period of disability.

Loss or Reduction of Benefits Social Security benefits can be terminated or reduced under certain conditions. Mothers and fathers lose their benefits when they are no longer caring for an eligible child under 16 (or are no longer caring for a disabled child over age 16). Children generally lose their benefits when they reach age 18, with the exception that benefits continue

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if the children are attending elementary or high school, or become disabled before age 22. Death or recovery from disability also cause the benefits to terminate. In addition, OASDI benefits to convicted felons are suspended while the recipients are in prison. Benefits are also suspended if the person is deported because of conviction for a crime or because of conviction for certain crimes committed against the United States, such as treason or espionage. Finally, benefits generally terminate if the beneficiary marries a person who is not receiving dependents’ or survivor benefits. One exception is a beneficiary who remarries after age 60.

Earnings Test The Social Security program has an earnings test (retirement test) that can result in a loss of monthly benefits. If a beneficiary has earnings in excess of some maximum annual limit, he or she will lose part or all of the benefits. The purposes of the earnings test are to restrict the monthly cash benefits only to those persons who have lost their earned income and to hold down the costs of the program. Attainment of Full Retirement Age

The earnings test does not apply after the beneficiary attains the full retirement age. Beneficiaries who have attained the full retirement age or beyond can earn any amount and receive full Social Security benefits. As an alternative, beneficiaries who continue working beyond the full retirement age can elect to receive a delayed retirement credit instead of monthly cash benefits. Beneficiary Under the Full Retirement Age

If the beneficiary is under the full retirement age, $1 in benefits will be deducted for each $2 in excess of the annual limit. For 2011, the annual limit was $14,160. The annual limit is increased annually based on increases in average wages in the national economy. If benefits are reduced because of earnings, the benefits will be recalculated and increased at the worker’s full retirement age to take into account those months in which benefits were withheld. Example: James, age 62, is a retired engineer who returns to work as a part-time consultant and earns $20,480 in 2011. His earnings are $6,320 above the annual exempt amount of $14,160. James will lose $3,160 in retirement benefits. Calendar Year in Which the Beneficiary Attains the Full Retirement Age

The earnings test is liberalized for this age group. In the calendar year in which the beneficiary attains the full retirement age, $1 in benefits will be deducted for each $3 above the annual limit. For 2011, the annual limit was $37,680. However, only months before the month in which the beneficiary attains the full retirement age are counted.

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Example: Brenda attains the full retirement age in July 2011. During the first six months of 2011, Brenda earned $40,680. Because her earnings are $3,000 over the annual limit of $37,680, $1,000 in benefits will be withheld. Exceptions to the Earnings Test

The earnings test has three major exceptions. First, as stated earlier, beneficiaries who attain the full retirement age can earn any amount and receive full benefits. Second, the earnings test does not apply to investment income, dividends, interest, rents, pensions, or annuity payments. The purpose of this exception is to encourage private savings and investments to supplement the Social Security benefits. Finally, a special monthly earnings test is used for the initial year of retirement that benefits workers who retire mid-year with earnings in excess of the annual earnings limit. The purpose of the special monthly test is to pay full retirement benefits, starting with the first month of retirement, to the worker who retires during the year with earnings in excess of the annual limit. Otherwise, the worker would lose part or all of the benefits for the months after retirement if the earnings exceeded the annual limit. Under the special test, the monthly exempt amount is one-twelfth of the annual exempt amount ($1,180 in 2011 for people younger than the full retirement age). For the initial year of retirement, regardless of total earnings for the year, full benefits are paid to a beneficiary who does not earn more than the monthly exempt amount or perform substantial services in self-employment. Example: Scott retires at age 62 on June 30, 2011. His earnings through June are $45,000. He takes a part-time job beginning in July and earns $500 per month. Although his earnings exceed the annual limit, he will receive Social Security benefits because his monthly earnings are less than the monthly limit. Beginning in 2012, only the yearly limit will apply to him. If the worker is self-employed, the amount of time working in the business is used to determine if the worker has retired. In general, if the worker works more than 45 hours a month in self-employment, he or she is not retired; if less than 15 hours a month, the worker is considered retired. If the amount of work is between 15 and 45 hours a month, the worker is not considered retired if it is in a job that requires considerable skill, or if the worker is managing a sizable business.

Government Pension Offset Benefits can also be reduced by the government pension offset. If a spouse or surviving spouse who is receiving Social Security benefits as a dependent or survivor is also receiving a pension based on federal, state, or local government employment not covered by Social Security, the Social Security benefit is reduced in an amount equal to two-thirds of the public pension. The purpose of the government offset is to reduce the problem of windfall benefits, or double dipping, by which a person work-

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ing in noncovered government employment could otherwise receive a sizable pension based on that employment and also from Social Security benefits as a dependent or surviving spouse.

Taxation of Social Security Benefits Some beneficiaries who receive monthly cash benefits must pay an income tax on part of the benefits. The amount of benefits subject to taxation depends on the taxpayer’s total combined income. Combined income is the sum of adjusted gross income, plus tax-exempt bond interest, plus one-half of the Social Security benefits. If your combined income exceeds certain dollar thresholds, some benefits may be taxable as shown below: • If you file a federal tax return as an individual and your combined income is between $25,000 and $34,000, up to 50 percent of the benefits is subject to taxation. If your combined income exceeds $34,000, up to 85 percent of the benefits is subject to taxation. • If you file a joint return and you and your spouse have a combined income between $32,000 and $44,000, up to 50 percent of the benefits is subject to taxation. If your combined income exceeds $44,000, up to 85 percent of the benefits is subject to taxation. • For married taxpayers who file separate returns and have lived together anytime during the year, the dollar threshold is zero. If not living together, you are considered to be a single person. The Social Security Administration sends a form to the beneficiary showing the amount of Social Security benefits received during the year. The Internal Revenue Service has a detailed worksheet to determine the amount of benefits, if any, to include in taxable income.

Financing the Social Security Program The Social Security program is financed by a payroll tax paid by covered employees, employer, and the self-employed; interest on the trust fund investments; and revenues derived from the taxation of part of the Social Security benefits. In 2010, a covered employee paid a Social Security payroll tax of 6.2 percent on taxable earnings up to $106,800; the employer also paid the same tax rate of 6.2 percent on the same wage base. The maximum taxable earnings base is adjusted annually based on changes in average wages in the national economy if benefits are increased based on the automatic cost-of-living provisions. In addition, both the employee and employer paid a Medicare tax of 1.45 percent for Hospital Insurance (Part A) on all covered earnings, including those that exceed the Social Security taxable wage base. In 2011, to help stimulate the economy, the payroll tax rate for employees was temporarily reduced 2 percentage points to 4.2 percent on earnings up to $106,800. The

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temporary reduction applied only to employees and not to employers. The temporary payroll tax reduction will expire at the end of 2011 unless extended by Congress. In 2010, the self-employed paid a payroll tax of 12.4 percent on covered earnings up to $106,800 and a Medicare tax of 2.9 percent on all covered earnings, including those that exceed the taxable wage base, or a total rate of 15.3 percent. However, the self-employed receive certain deductions that reduce the effective tax rate. In 2011, the tax rate for the self-employed was temporarily reduced to 13.3 percent for one year to help stimulate the economy, as discussed earlier. Beginning in 2013, the Hospital Insurance payroll tax will be increased 0.9 percent (1.45 percent to 2.35 percent) on earnings over $200,000 for single persons and $250,000 for married couples filing jointly. The additional payroll tax on high-wage earners is part of the financing provisions under the new Patient Protection and Affordable Care Act. All tax contributions and premiums are deposited into federal trust funds. All sums needed for the various benefits and administrative expenses are paid out of the trust funds. The excess contributions not needed for current benefits and administrative expenses are invested in government securities. The trust funds are discussed in greater detail in Chapter 7.

Administration The OASDI program is administered by the Social Security Administration, which is an independent agency in the executive branch of the federal government. The Medicare program is administered by the Centers for Medicare and Medicaid Services (CMS), which is part of the U.S. Department of Health and Human Services. District offices provide local residents with information and assistance in filing OASDI claims. A toll-free telephone number and a Web site are also available for obtaining information. If the worker is employed in a covered occupation, he or she needs a Social Security card. The number on the card is used to record covered earnings. The earnings record is kept by the Social Security Administration at its central office in Baltimore, Maryland. Only one Social Security card is needed during the worker’s lifetime. If the card is lost, a duplicate card will be issued. Workers should periodically check on their Social Security earnings for possible errors. The Social Security Administration sends out an annual statement that shows the earnings on which Social Security taxes have been paid and a summary of the estimated benefits payable as a result of those earnings. The statement is provided in two ways: automatic annual mailings to workers and former workers ages 25 and older, and at any time to workers of any age who request one.

Summary • Most workers in private industry are currently covered under Social Security. Excluded occupations include civilian federal employees hired before 1984, railroad workers covered under the Railroad Retirement System, certain employees

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of state and local governments, domestic workers and farm workers with low earnings, and persons with very low net earnings from self-employment. • A certain number of credits for working are necessary to qualify for benefits. In 2011, covered workers received one credit for each $1,120 in covered earnings up to a maximum of four credits for the year. • A fully insured status requires 40 credits or 10 years of work. A currently insured status requires at least six credits out of the last 13 quarters ending with the quarter of death, disability, or entitlement to retirement benefits. • A disability-insured status generally requires a disabled worker to meet two tests: (1) a recent work test based on age at the time of disability, and (2) a duration-ofwork test to show that the worker has worked long enough under Social Security to qualify for benefits. The actual number of credits required to meet these two tests depends on the worker’s age. • The retirement benefit amount depends on the worker’s primary insurance amount, average monthly indexed earnings, and any credits for delayed retirement. The benefits are automatically adjusted each year for measurable changes in the Consumer Price Index. • The full retirement age is the age at which full unreduced benefits are paid. The full retirement age ranges from age 65 to age 67, depending on the worker’s date of birth. The early retirement age is age 62, with reduced benefits. • Retirement benefits can be paid to a fully insured retired worker, to a spouse at least age 62, to unmarried children under age 18, and to unmarried disabled children who became disabled before age 22. • Survivor benefits can be paid to unmarried children under age 18 (age 22 if disabled); to a surviving spouse at any age caring for a child under age 16 or to a disabled child who is receiving Social Security benefits; to a surviving spouse age 60 or over; to a disabled widow or widower, ages 50–59, under certain conditions; and to dependent parents. • To be eligible for benefits, a disabled worker must be disability insured, meet the definition of disability stated in the law, and fulfill a full five-month waiting period. Disability is defined as the inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment(s), which can be expected to result in death or has lasted or is expected to last for a continuous period of at least 12 months. • Disability benefits can be paid to eligible disabled workers, to the spouse of a disabled worker caring for a child under age 16 (or disabled before age 22), to unmarried children under age 18, to a person disabled before age 22 who is entitled to benefits based on the earnings of a parent, and to a divorced spouse under certain conditions. • The disability income program has several work incentives to encourage disabled workers to return to work, including a trial work period, extended period of disability, expedited reinstatement, deduction of work-related expenses from earnings, continuation of Medicare coverage, and a “ticket” to work.

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• The Social Security program has an earnings test that can result in the loss of monthly benefits. The test applies to beneficiaries under the full retirement age. If a beneficiary has earnings in excess of some maximum annual limit, he or she will lose part or all of the benefits. If benefits are reduced because of earnings, they will be recalculated and increased at the worker’s full retirement age to take into account those months in which benefits were withheld. • The Social Security program is financed by a payroll tax paid by covered employees, employers, and the self-employed; interest on the trust fund investments; and revenues derived from the taxation of part of the Social Security benefits.

Review Questions 1. Identify the occupations that are excluded from Social Security coverage. 2. Explain the meaning of fully insured, currently insured, and disability insured. 3. Briefly explain how the primary insurance amount (PIA) is calculated. 4. Explain the difference between the full retirement age and early retirement age. 5. Identify the various categories of family members who may be eligible for OASDI retirement and survivor benefits. 6. Explain the eligibility requirements for disability income benefits. 7. Briefly explain the definition of disability that is used in the disability income program. 8. Briefly describe the work incentives that are present in the disability income program to encourage disabled workers to return to productive employment. 9. Briefly explain the earnings test under the OASDI program. 10. How is the Social Security program financed? Explain your answer.

Application Questions 1. Explain whether each of the following people would be eligible for Social Security retirement benefits based on the retired worker’s earnings record. Treat each item separately. a. A retired worker’s spouse, age 50, who is caring for the 15-year-old daughter of the retired worker. b. A retired worker’s unmarried son, age 30, who became totally disabled at age 16 because of an auto accident. c. A spouse, age 62, who is no longer caring for an unmarried child under age 16. d. A divorced spouse, age 55, who was married to the retired worker for 5 years. 2. Explain whether each of the following persons would be eligible for Social Security survivor benefits based on the deceased worker’s earnings record. Treat each item separately. a. A dependent daughter, age 20, who is attending college full time. b. A surviving spouse, age 60, who has been out of the labor force for several years.

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c. A surviving spouse, age 35, who is caring for an unmarried child, age 16. d. A surviving spouse, age 55, who has no children under age 16 in her care. e. A dependent parent, age 80, who was receiving financial help from the deceased worker. 3. Explain whether each of the following persons would be eligible for disability income benefits. In each case, assume that the disabled worker is disability insured. Treat each item separately. a. A female worker, age 48, who fell down an unlit stairway and broke her leg but is expected to return to work in two months. b. A disabled worker’s spouse, age 28, who is caring for a dependent child, age 4. The disabled worker is currently receiving benefits. c. A disabled worker’s unmarried daughter, age 16, who is attending high school full-time. d. A chemistry professor, age 50, who can no longer teach because of chronic laryngitis but can work as a research scientist for a pharmaceutical company. e. A male worker, age 50, who has a crushed foot and expects to be off work for at least one year.

Internet Resources • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on Social Security and Medicare on its Web site. Visit the site at www.nasi.org • The National Commission to Preserve Social Security & Medicare has the goal to protect, preserve, promote, and ensure the financial security, health, and well-being of current and future generations of older Americans. The organization issues timely articles and studies on the current Social Security and Medicare programs. Visit the site at www.ncpssm.org • Social Security Online is the official Web site for the Social Security Administration, which administers the Social Security (OASDI) program in the United States. The site provides updated information on retirement, survivor, and disability benefits and recent changes in the program. Visit the site at www.socialsecurity. gov or www.ssa.gov • MyMedicare is the official U.S. government site for people on Medicare. The site provides a secure online service for accessing personal information for beneficiaries. It gives claims information, comparison of health and drug plans, and health management information. Visit the site at www.MyMedicare.gov • The Office of the Chief Actuary in the Social Security Administration provides actuarial cost estimates of the OASDI program and determines the annual costof-living adjustments in OASDI benefits. The site provides a number of timely publications. Visit the site at www.socialsecurity.gov/OACT • The Social Security Advisory Board advises the president and Congress on issues relating to the Social Security program in the United States. The site provides timely and relevant reports dealing with Social Security. Visit the site at www.ssab.gov

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Selected References Committee on Economic Security. Social Security in America: The Factual Background of the Social Security Act as Summarized from Staff Reports to the Committee on Economic Security. Washington, DC: U.S. Government Printing Office, 1937. Myers, Robert J. Social Security. 4th ed. Philadelphia: Pension Research Council and University of Pennsylvania Press, 1993. Social Security Administration. Annual Statistical Supplement to the Social Security Bulletin, 2010. February 2011. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office, 2011. 2011 CCH Social Security Explained. Chicago: Wolters Kluwer, 2011.

Notes 1. This chapter is based on information found at Social Security Online (www.socialsecurity.gov), the official Web site of the U.S. Social Security Administration. The site provides updated changes and current material on the Social Security program. 2. The history of the development of the Social Security Act of 1935 can be found in Committee on Economic Security, Social Security in America: The Factual Background of the Social Security Act as Summarized from Staff Reports to the Committee on Economic Security (Washington, DC: U.S. Government Printing Office, 1937). See also “Social Security Programs in the United States.” Social Security Bulletin, no. 4 (Winter 1993). 3. U.S. Government Accountability Office, Social Security: Coverage of Public Employees and Implications for Reform. Testimony Before the Subcommittee on Social Security, Committee on Ways and Means, Statement of Barbara D. Bovbjerg, Director of Education, Workforce, and Income Security, GAO-05–786T, June 9, 2005. 4. This section is based on Social Security Administration, SSA Publication No. 05-10029, July 2011. 5. Ibid. 6. Ibid. 7. Social Security Online, “Automatic Increases, Social Security Benefit Amounts.” Available at www.ssa.gov/OACT/COLA/Benefits.html 8. Figures shown are from The 2010 Annual Report of the Board of Trustees of the Federal OldAge and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2010), Table VI.F10 and Table VI.F6. 9. Robert Rosenblatt, National Academy of Social Insurance, Social Security: An Essential Asset and Insurance Protection for All. Social Security Brief, no. 26, February 2008. 10. Ibid. 11. Working While Disabled—How We Can Help, SSA Publication No. 05-10095, January 2011.

6 Problems and Issues in the Social Security Program

Student Learning Objectives After studying this chapter, you should be able to: • Evaluate the arguments for an increase in the full retirement age. • Explain whether Social Security (OASDI) retirement benefits are adequate. • Explain the reasons why a large proportion of disability income claims are ­denied. • Explain the appropriateness of the current definition of disability under the disability income program. • Describe the attitudes of Americans toward the Social Security program. • Evaluate the viewpoint that workers do not receive their money’s worth under the Social Security program. • Explain the proposal for reducing payroll taxes to stimulate output and ­employment. The Social Security program is the most important social insurance program in the United States that provides meaningful economic security to millions of Americans. However, the present program has a number of timely problems and issues that must be resolved. In this chapter, we examine several important problems and issues in the OASDI program. Because of their special importance, financing problems and the future solvency of Social Security are discussed in Chapter 7. Medicare problems and issues are discussed in Chapter 10.

Higher Full Retirement Age A timely question is whether the full retirement age for unreduced benefits should be increased. Under present law, the full retirement age ranges from age 65 for those born in 1937 or earlier to age 67 for those born in 1960 or later. The higher full retirement age of 67 will not become fully effective until 2027. Early retirement is still 124

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permitted at age 62, but the actuarial reduction in benefits will gradually rise from 20 percent to 30 percent (from 25 percent to 35 percent for spouses) in the future. Medicare benefits for the aged are still available starting at age 65.

Arguments for Higher Full Retirement Age Proponents of a higher full retirement age present several arguments based on demographic, financial, and economic considerations. They include the following: • Increase in Life Expectancy. It is argued that a higher full retirement age is necessary because of the increase in life expectancy at the older ages. Based on a report by the Board of Trustees of the Federal OASDI and Federal Disability Insurance Trust Funds, when Social Security retirement benefits were first paid at age 65 in 1940, males had a remaining life expectancy of 12.7 years, and females had a life expectancy of 14.7 years. In 2010, life expectancy at age 65 is 18.1 years for males and 20.4 years for females.1 In short, since the Social Security program first began paying benefits at age 65, life expectancy has increased between five and six years for both males and females. Since older workers are expected to live longer in the future, a higher full retirement age is justified. However, it should be noted that the increase in life expectancy is not uniform for all groups in the population. Research studies show a growing disparity in longevity between high-income and low-income individuals and between those with more and less education. High-wage earners and highly educated workers have experienced greater increases in life expectancy over time than low-wage workers. The slower increase in life expectancy for low-wage workers is not concentrated solely in a small group of disadvantaged individuals at the lowest end of the income scale but includes the entire bottom half of the population.2 Thus, unless the longevity gap between low-wage and high-wage workers is reduced in the future, a higher full retirement age will have a greater financial impact on low-wage employees than on high-wage employees. Likewise, blacks, Native Americans, and other minority groups have a lower life expectancy than upper-income and highly educated workers. An increase in the full retirement age will also have a greater financial impact on this group. • Longer Period of Productive Earnings. Proponents argue that a higher full retirement age will encourage older workers to remain in the labor force longer because their early retirement benefits will be smaller. Under present law, the actuarial reduction in benefits at age 62 will gradually increase from 20 percent to 30 percent. Because of the larger actuarial reduction in benefits, many older workers may remain in the labor force for longer periods. As a result, the period of productive earnings will increase, which will enable older workers to accumulate additional savings, thereby reducing economic insecurity during the period of actual retirement. • Substantial Reduction in Long-Range Actuarial Deficit. Another argument is that a gradual increase in the full retirement age will have a significant impact on the reduction in the projected long-range actuarial deficit. The Social Security

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program will experience a substantial long-range actuarial deficit in the years ahead. Based on the 2011 Board of Trustees report, the projected 75-year actuarial deficit is 2.22 percent of taxable payroll.3 Several proposals for a higher full retirement age have been put forth to address the long-range deficit. One proposal is to speed up the increase in the full retirement age to 67 and then gradually increase it to 68. According to the Social Security Advisory Board, this proposal would reduce the 75-year actuarial deficit by 23 percent.4

Arguments Against a Higher Retirement Age Several counterarguments are offered against a higher future retirement age. They include the following: • Reduction in Benefits. Opponents of a higher retirement age maintain that a higher retirement age will reduce benefits, since the benefits will be paid over a relatively shorter retirement period. As a result, total benefits would be lower at all ages at retirement. • Harmful to Minority Workers and Other Low-Income Workers. It is argued that a higher retirement age will be harmful to minority workers (blacks, Hispanics, and Native Americans) who have lower life expectancies than the general population. It is also argued that many minority workers will die before age 67 or some higher retirement age and never receive any retirement benefits. • Harmful to Older Workers with Health Problems. Another argument against a higher retirement age is that older workers with health problems will be harmed. It is argued that many older workers in poor health may not be able to meet the strict definition of disability to qualify for disability income benefits; thus, they will be forced to remain in the labor force for a longer period to collect full retirement benefits. Also, although older workers in poor health will still have the option of retiring early at age 62, they will be faced with a larger actuarial reduction in their benefits. Finally, a higher retirement age will increase health insurance costs for employers. • Reduction in Job Opportunities for Younger Workers. Another argument against a higher future retirement age is that job and promotion opportunities for younger workers will be reduced. If older workers remain in the labor force longer because of a higher retirement age, their jobs do not become available to younger ­workers. • Higher Disability Income Costs. Finally, it is argued that a higher full retirement age could increase disability income costs. Impaired workers under the full retirement age may be encouraged to file for disability income benefits in order to avoid the increased actuarial reduction in benefits for early retirement.

Adequacy of Benefits Social Security benefits are critically important to the elderly in providing income during retirement. In 2008, Social Security retirement benefits provided at least half of the total income for the majority of elderly beneficiary households. The benefits are

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especially important for low-income aged couples and aged nonmarried beneficiaries. The benefits provided 90 percent or more of the total income for 21 percent of aged beneficiary couples and 43 percent for aged nonmarried beneficiaries.5 Without these benefits, the majority of beneficiaries would have been exposed to serious economic insecurity. In 2008, the aged poverty rate was 9.7 percent. Without Social Security, the poverty rate would have increased sharply to 45.2 percent. The Social Security program lifted 13 million elderly Americans out of poverty.6 Whether or not the benefits are adequate is an important issue that merits some discussion. In Chapter 2, we noted that the Social Security program provides only a minimum floor of income. However, there is considerable disagreement concerning the meaning of a “minimum floor of income.” Whether monthly Social Security benefits are adequate depends on the measure of adequacy selected. Benefit adequacy can be measured by poverty thresholds, by replacement rates, by the effectiveness in protecting vulnerable groups, and by the proportion of beneficiaries who are kept off of welfare.

Poverty Thresholds Although Social Security benefits have a powerful impact in reducing aged poverty, poverty thresholds are seriously flawed as a measure of benefit adequacy.7 In 2009, the poverty threshold for individuals age 65 and over who lived alone was $10,289. At the end of 2009, the average monthly benefit for retired workers in a current-payment status was $1,164, or $13,704 annually. Although that amount exceeds the poverty threshold, it is incorrect to assume that the benefits are adequate for several reasons. First, poverty thresholds do not consider medical expenses, the cost of prescription drugs, long-term care costs, health insurance premiums, housing costs, and utility costs, all of which have increased substantially in recent years. These costs are significant in the budgets of the aged. Second, many retirees receive considerably less than the average monthly OASDI benefit because of early retirement and reduced benefits, intermittent employment, or repeated spells of unemployment, which reduces average earnings. Third, workers who are steadily employed at the federal minimum wage rate and retire at age 62 would receive benefits that are substantially below the poverty thresholds. Finally, poverty thresholds do not reflect (1) improvements in the standard of living over time because of economic growth or (2) changes in consumer expectations and spending patterns. Consequently, poverty thresholds tend to significantly underestimate the amount of income needed to pay living expenses for the average retired beneficiary. Studies have shown that retired workers need substantially higher incomes than that provided by Social Security alone to pay their living expenses.

Replacement Rates The replacement rate is the percentage of earnings replaced by Social Security benefits. It is an extremely useful concept, since it indicates the extent to which Social Security retirement benefits permit retired workers to maintain a standard of living reasonably close to the standard of living they attained prior to retirement.

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Financial planners, pension experts, and many research studies generally recommend a replacement rate of 70 percent to 80 percent of gross earnings prior to retirement. This recommendation typically includes income from Social Security, private pension plans, 401(k) plans, savings and investments, and other sources. The 70 percent standard is a common target. Conventional wisdom assumes that the retired worker is in a lower marginal tax bracket; the mortgage is paid off; work-related expenses are eliminated; Social Security benefits are not subject to payroll taxes; Social Security benefits receive favorable tax treatment; and the need to save during retirement is reduced or even eliminated. Thus, it is argued that retired workers do not need 100 percent of their gross earnings replaced to maintain their previous standard of living. The conventional views on replacement rates should be interpreted with caution and should not be applied unequivocally to all retired persons in view of current trends that can severely aggravate the financial problems of retirees. First, the federal government is currently experiencing historically high deficits. Because the federal income tax may be increased in the future to reduce the deficit, many retired persons may be in a higher marginal tax bracket after retiring. Second, many older workers going into retirement still have sizable mortgage loans; some older retired people have also incurred sizable home equity loans to pay medical bills, to travel, or to pay other household expenses. Third, the argument that retirees need less income because the need to save is reduced, and work-related expenses are eliminated, is also flawed. Retirees typically save part of their income to pay property taxes, to build up a fund for possible longterm care costs and other medical costs, or to leave a bequest to their children or to charity; and many older people work part time, in which case work-related expenses are not significantly reduced. Fourth, many grandparents care for or have custody of their grandchildren because of incarceration, drug addiction, or other family problems of one or both parents, which increases the need for additional household income. In addition, many adult children who lost their jobs during the severe economic downturn of 2008 and 2009 and are continuing to experience serious financial problems have moved back home with their parents, at least temporarily. As a result, many retired aged are now faced with increased expenses. Finally, the retired aged are faced with increased expenses that younger workers generally do not have. The majority of the aged suffer from chronic diseases; Medicare premiums must be paid; uninsured medical bills not covered by Medicare or supplemental Medicare policies must be paid; many beneficiaries are now faced with the crushing costs of long-term care in a skilled nursing facility. If long-term care policies are purchased, the premium costs can add several thousands of dollars of cost annually to a retiree’s budget. Many research studies on the adequacy of benefits have omitted or have placed inadequate weight on these variables. As a result, such families may require a replacement rate substantially higher than 70 percent to maintain their pre-retirement standard of living. How well do Social Security replacement rates measure up? As stated in Chapter 5, in 2010, the replacement rate at the full retirement age (age 66) was 56 percent

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for a low earner, about 42 percent for an average earner, about 35 percent for a high earner, and 28 percent for the maximum earner.8 The low earner earns about 45 percent of the average wage (as determined by the Social Security average wage index). The average earner has earnings equal to about 100 percent of the Social Security average-wage index. The high earner has earnings equal to about 160 percent of the average wage index. The maximum earner is a worker who has annual earnings equal to the maximum Social Security taxable wage and contribution base ($106,800 in 2010). In reality, the actual replacement rates for the majority of workers are significantly lower than the hypothetical replacement rates shown above. The replacement rates above assume the worker retires at the full retirement age. However, the majority of covered workers retire early, at age 62 or before the full retirement age, and receive actuarially reduced benefits. The reduced benefits can substantially lower the actual replacement rate. In addition, many workers, especially women who care for children or aged relatives, may not have a history of actual earnings that closely matches the pattern of earnings used by Social Security actuaries in their replacement examples. Women enter and leave the labor force more frequently than men, and many do not have a history of steady full-time earnings. As a result, the actual replacement rate may be substantially below the hypothetical rate. For example, in 2005, the average retirement benefit paid to new retirees replaced about 33 percent of the average wage for all workers in the prior year.9 If a retired worker is receiving additional retirement benefits from a defined-benefit or defined-contribution retirement plan, the replacement rate generally may be increased by an additional 10 percent to 20 percent. However, the problem here is that not all workers are covered under private retirement plans, and not all workers who are covered participate in the plans. In March 2010, only 65 percent of all workers in private industry had access to employer-sponsored retirement plans in private industry, and only 50 percent actually participated in the plans.10 Thus, retirees without pensions typically have replacement rates that fall substantially short of the 70 percent standard. When the preceding Social Security replacement rates are analyzed, two points must be emphasized. First, the social adequacy principle discussed in Chapter 2 is clearly evident. Low-wage earners have a much higher percentage of earnings replaced by Social Security than workers with higher incomes. Second, the floor-of-income principle discussed in Chapter 2 is also evident. Social Security benefits provide only a floor or base of income, rather than full replacement of a worker’s earnings. Retired workers are expected to provide additional amounts of income from their own financial resources, such as individual retirement accounts (IRAs), 401(k) plans, defined benefit pension plans, and savings and investments. Social Security benefits, however, provide a solid base of income protection to retired workers who obviously need additional amounts of income during retirement to maintain their previous standard of living. To attain a 70 percent replacement rate, however, some financial planners estimate that workers must save 10 to 15 percent of their pre-retirement earnings to accomplish this goal. Whether workers will increase their present rate of savings to accomplish this ambitious goal is problematic.

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Declining Future Replacement Rates Social Security net replacement rates are scheduled to decline in the future. The decline is due to three reasons. First, the gradual increase in the full retirement age from age 65 to 67 amounts to an across-the-board cut in benefits at every age. For workers born in or after 1960, benefits claimed at any age will decline about 13 percent.11 Second, Medicare premiums are increasing at a faster rate than Social Security benefits, which reduces the amount that can be spent. Finally, under current law, part of the benefits is not subject to income taxes, but the exempt amounts are not indexed for inflation. As a result, a larger proportion of beneficiaries will pay taxes on Social Security benefits in the future, and replacement rates will be lower. As a result of these factors, it is estimated that an average earner retiring at age 65 in 2030 will receive Social Security benefits that will replace about 29 percent of prior earnings, down from 39 percent in 2005.12

Protection of Vulnerable Groups Another measure of adequacy is the extent to which the present benefit structure protects vulnerable groups. It is beyond the scope of the text to discuss all vulnerable groups. However, three groups merit a brief discussion: • Aged widows • Long-service workers employed at low wages • Beneficiaries age 80 or older Aged Widows

A large proportion of aged widows who live alone are poor: it is estimated that 45 percent of the women in the United States who live alone after age 65 are poor.13 In the majority of families, the husband is the primary earner, and the wife may have worked intermittently or is not currently in the labor force. As a result, she may have relatively low earnings. At the full retirement age, the husband would receive a retirement benefit equal to his primary insurance amount. His wife at the full retirement age would receive a benefit equal to 50 percent of her husband’s primary insurance amount, or her own benefit if higher. The total income for the couple is 150 percent of the husband’s benefit. If the husband dies, the widow would receive 100 percent of her husband’s benefit, or her own benefit if higher. Thus, total income has been reduced by one-third, which may be insufficient for maintaining her previous standard of living. In the case of two earners with roughly equal earnings, each spouse receives his or her own retirement benefit. If one spouse dies, the surviving spouse receives the higher of the two individual benefits. If both benefits were the same, the income to the surviving spouse would be only 50 percent of the married couple’s prior income. As a result, the previous standard of living would be difficult to maintain. One proposal to correct the benefit inequity would be to pay the surviving spouse

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a new benefit equal to 75 percent of the sum of the worker benefits received by both spouses. Studies show that surviving spouses require about 75 percent of the combined income that both spouses received to maintain the same standard of living.14 The problem of an older widow under age 60 with no eligible children in her care is especially difficult to resolve. Older widows under age 60 with grown children often do not have a current attachment to the labor force at the time of their husbands’ death. They may have withdrawn from the labor force years before being widowed. For example, a widow age 55 who has no eligible children under age 16 in her care, and is not disabled, would not be eligible for survivor benefits until age 60. If the deceased husband has insufficient life insurance, or family savings or other sources of income are inadequate, she might be forced to find a job. However, employment opportunities may be limited because of high unemployment in the community, inadequate or obsolete work skills, or an ineffective job search. Older widows in this category with limited employment opportunities could find it extremely difficult to attain meaningful economic security. Long-Service Workers Employed at Low Wages

Workers who have worked their entire career at low wages are especially vulnerable to economic insecurity during retirement. This is especially true for long-service employees who are paid the federal minimum wage, or earn slightly higher wages, throughout their working career. The annual retirement benefits paid to low-wage workers who earned minimum wages throughout their careers, especially workers retiring at age 62, are substantially below the poverty line. A special minimum benefit provision was enacted in 1972 to increase the adequacy of benefits for low-wage, long-service workers. However, because the special minimum benefit is not indexed to keep pace with the increase in wages over time, it is ineffective in providing adequate benefits to a vulnerable group. One proposal is to increase the minimum retirement benefit to 120 percent of the poverty line for minimum wage workers who have worked for 30 years. Beneficiaries Age 80 or Older

Because of the increase in life expectancy, many beneficiaries survive to age 80 or beyond. These older beneficiaries, age 80 or older, are especially vulnerable to economic insecurity during their remaining lifetime. Their savings may be exhausted; relatively few beneficiaries age 80 or older are in the labor force and have work earnings; and many beneficiaries in this age category do not receive additional income from private pensions. In addition, for beneficiaries who do have private pensions, the benefits typically are not indexed for inflation. As a result, the purchasing power of the benefits erodes over time as prices increase. Longevity insurance has been proposed as a possible solution for providing more adequate benefits to this group. One proposal would increase retirement benefits 10 percent at age 85 for beneficiaries with 30 years of work whose benefits are lower than 75 percent of the average benefit that all workers receive.

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Social Security Benefits and Public Assistance A final measure of benefit adequacy is to determine the proportion of aged beneficiaries who are forced to apply for supplemental public assistance benefits to meet their basic needs. Low-income workers with inadequate Social Security benefits who can meet a stringent needs test may be eligible for additional monthly benefits under the Supplemental Security Income (SSI) program. However, in 2008, only 2 percent of the married couples age 65 or older and 5 percent of the nonmarried persons age 65 or older reported receiving income from SSI.15 Thus, Social Security benefits can be considered reasonably adequate in keeping beneficiaries off welfare.

National Retirement Risk Index The Center for Retirement Research at Boston College has developed a National Retirement Risk Index that measures the percentage of working-age households that are at risk of being unable to maintain their pre-retirement standard of living after they retire. The index addresses one of the most compelling challenges facing the nation today: ensuring retirement security for an aging population. The index compares the households’ projected replacement rates with target rates that would allow them to maintain their present standard of living during retirement. The index assumes that the household head retires at age 65, annuitizes all financial assets, and also receives income from a reverse mortgage from equity in the home. Figure 6.1 shows clearly that many workers will be unable to maintain their present standard of living after they retire. The numbers shown indicate the percentage of working-age households who are at risk of not having sufficient income to maintain their standard of living in retirement. The higher the percentage, the greater the percentage of working-age households who are at risk of not having sufficient retirement income to maintain their standard of living in retirement. In 2009, 51 percent of the households were “at risk” of not having sufficient income to maintain their living standards in retirement. Although not shown, if health-care costs are included in the index, the percentage of households at risk is increased to 61 percent; and if long-term care costs are also included, the percentage of households at risk is increased further to 65 percent.16 However, increased saving and working longer may substantially improve the retirement outlook.

Disability Income Problems and Issues Millions of disabled workers and their families receive monthly disability income benefits. Although these benefits provide considerable economic security to disabled beneficiaries, certain problems and issues must be resolved. They include the following: • Large backlog of pending claims • High proportion of initial claims denied • Appropriateness of the present definition of disability • Recent work test requirement

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Figure 6.1  The National Retirement Risk Index, 1983–2009  



 

























 











Source: Center for Retirement Research, Boston College. Note: The higher the percentage, the greater the percentage of working-age households who are at risk of not having sufficient retirement income to maintain their standard of living in retirement.

Large Backlog of Pending Claims A critical problem at the present time is the large backlog of pending disability claims. At the beginning of March 2010, the number of disability hearings pending totaled 697,437 cases. In addition, the average processing time for hearing decisions is 442 days, down from a high of 514 days at the end of fiscal year 2008.17 The lengthy delay in disability hearings can cause great economic insecurity for disabled claimants. Workers experiencing an extended disability must rely primarily on Social Security benefits as their major source of income. Many disabled workers are not covered under an individual disability income policy or under an employersponsored group short-term or long-term plan. In addition, disabled workers may have insufficient savings to finance an extended disability. Moreover, even after a lengthy delay, the claim may be denied. If a disabled worker appeals the denial, he or she may have to hire an attorney for assistance in the appeal process.

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To reduce the backlog of claims, the Social Security Administration plans to hold more hearings, hire more administrative law judges and support staff, and has aggressive plans to open new hearing offices.

High Proportion of Initial Claims Denied A fundamental objective of Social Security is to provide a base of protection against certain risks that create economic insecurity, including the risk of long-term disability. This objective is not being met at the present time because of the unusually high denial rate of initial claims. The majority of applicants who file for disability benefits are initially turned down. During the period from 1999 to 2008, the percentage of applicants awarded disability benefits at the initial claims level averaged only 28 percent. On appealed claims, at the reconsideration and hearing levels, the percentage of applicants awarded benefits averaged only 3 percent and 13 percent, respectively.18 Many claims are denied because the applicant’s condition does not meet the strict definition of disability in the Social Security program and the applicant is considered capable of working in substantial gainful activity. Other claims are denied because applicants are not disability insured, do not meet the recent work test requirement, fail to meet other eligibility requirements, or are denied benefits because of nonmedical, technical reasons. There is considerable evidence that some disabled persons who are initially denied benefits are truly disabled. Many denied claims are ultimately reversed upon appeal because administrative law judges assess an applicant’s functional ability using standards and procedures that differ from those used in the initial disability determination by the state agency. Administrative law judges generally rely more on symptoms, such as pain and fatigue, whereas adjudicators who make the initial disability determination rely on medical evidence, such as laboratory tests.19 The result is an inconsistency between the state agency and administrative law judge in determining disability, which raises questions about the fairness and integrity of the disability income program. In summary, the majority of applicants may be sick enough to file a claim but not sick enough to initially qualify for benefits. As stated earlier, the claim process is lengthy, and disabled persons must often wait one year or longer to receive benefits. As result, they are exposed to considerable economic insecurity during the interim period.

Appropriateness of the Present Definition of Disability Another important issue is whether the current definition of disability is appropriate in view of technological and medical advances that enable some disabled beneficiaries to work. A strict definition of disability is used in the Social Security program. Disability is defined as the inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment(s), which can be expected to result in death or has lasted or is expected to last for a

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continuous period of at least 12 months. The disabled worker must also satisfy a full 5-month waiting period and meet a recent work test and duration-of-work requirement. The preceding definition of disability can be criticized on several grounds. First, changes in the labor market and improvements in medical devices and technology have enabled an increasing number of workers with disabilities to find employment. Advances in wheelchair design and assistive technologies have given more independence to many people. In addition, the economy is now oriented toward knowledge and services, which has opened up new employment opportunities for many people with disabilities. Despite severe impairments, many such workers are highly successful in their jobs. However, according to the U.S. Government Accountability Office, criteria for disability income benefits have not kept pace with these advances and changes.20 Thus, questions can be raised concerning the validity of defining disability in terms of the inability to work. Second, the present program sends conflicting signals to disabled workers that may discourage working. The process of collecting disability benefits can be slow and demanding. After meeting a five-month waiting period and other eligibility requirements, benefits may be payable. Once the benefits start, beneficiaries are told that regular work earnings exceeding a certain amount can cause their benefits to be terminated. However, at the same time, some beneficiaries are referred to employment and training programs for possible reentry into the labor force. In short, disabled beneficiaries must devote a considerable amount of time and effort to proving that their impairments prevent them from working and, at the same time, are encouraged to work at the cost of forfeiting their benefits. Third, the vast majority of disability beneficiaries never return to work. Critics argue that the low rehabilitation rate is due more to disincentives in the program itself rather than to the actual impairments incurred by the beneficiaries. Finally, the present definition of disability may impose a severe hardship on older disabled workers. Disabled younger workers have a greater potential for successful retraining and adjustment to a different line of work. However, this is not true for many older workers with disabilities, who may withdraw from the labor force because of poor health. They might be considered incapable of working at their regular jobs, but not at some other job, since they are not totally disabled. As a practical matter, however, they are often unable to find another job yet do not qualify for disability benefits because they are considered capable of working in some substantial gainful activity. Several proposals have been made that would liberalize the definition of disability for disabled workers age 55 and over. For example, disability could be defined in terms of the worker’s occupation or occupational skills, which would be more liberal than the disability definition now used. Older workers would be considered disabled if they cannot engage in any substantial gainful activity that requires skills or abilities similar to those required in jobs in which they have previously worked with some regularity over a substantial period of time. However, adopting a more liberal definition of disability will substantially increase the cost of the disability insurance program and make new corrective legislation more difficult to enact.

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Recent Work Test Requirement The recent work test requirement is another issue that merits some discussion. In order to become disability insured, a person with a disability must meet a recent work test that is designed to limit benefits only to workers who have a recent attachment to the labor force. So a person might satisfy the definition of disability but have the claim disallowed because of failure to meet the work test. The number of credits needed to meet the recent work test requirement depends on one’s age upon becoming disabled. Workers age 31 or older need 5 years of work out of the 10-year period ending with the quarter the disability began. In contrast, a worker under age 24 is treated more favorably, since he or she needs only 1.5 years of work in the 3-year period ending in the quarter when the disability begins. The recent work test provision is clearly inequitable to some women over age 31 and to other workers who work intermittently. Women who must drop out of the labor force to care for their children or aged parents may be denied disability benefits despite the fact that they have worked previously for a substantial number of years. Also, the recent work test requirement can result in a denial of benefits to some disabled persons who formerly were steady workers, but whose working ability has been gradually reduced over a period of time because of a progressive impairment. The result is that some workers who have paid into the Social Security program for many years fail to qualify for benefits because they cannot meet the recent work test requirement.

Public Confidence in the Social Security Program Another important issue is whether Americans are satisfied or dissatisfied with the current Social Security program. The program has been under heavy attack in recent years, and it is important to determine if the public currently has confidence in it. Polls in the 1980s and 1990s indicated that the public was dissatisfied with the Social Security program. This lack of public confidence was due to numerous factors: (1) underfunding of the Social Security program and an expected future long-term actuarial deficit; (2) decline in the value of Social Security benefits relative to taxes paid, especially by younger workers; (3) concern that Social Security benefits will not be available when workers retire in the future; and (4) greater confidence by workers in their own private savings and employer-sponsored private pension plans. However, a recent poll sponsored jointly by the National Academy of Social Insurance and the Rockefeller Foundation indicates a more positive public attitude toward Social Security. Although many Americans still lack confidence in Social Security, the poll revealed that the public generally supports the current program, especially in view of its importance during the recent financial meltdown and economic crisis. In July and August 2009, the Benenson Strategy Group conducted a telephone survey of 1,488 people to determine their attitudes toward the Social Security program. The survey was conducted when the United States was experiencing the second worst economic downswing in its history with historically high unemployment rates and widespread fear and anxiety throughout the nation. Some important findings are summarized as follows:21

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• Americans say they need Social Security now more than ever in view of the recent financial crisis. Nearly 9 in 10 Americans (88 percent) say that with the bad economy and poor stock market, Social Security benefits are more important than ever to ensure that retirees have a dependable source of income when they retire. • While Americans lack confidence in the future of Social Security, they want it to be there. The vast majority (90 percent) of Americans say they are concerned about the program’s ability to pay benefits. Less than half (44 percent) of nonrecipients believe Social Security will be available to them when they retire. However, the vast majority (88 percent) want the benefits to be there. • Americans are willing to pay for Social Security because they value it for themselves, their families, and the millions of others who rely on it. A large majority (87 percent) of Americans say they do not mind paying Social Security taxes because the program helps millions of other people, and they or their families might need it someday. • Americans support benefit improvements and favor raising taxes over reducing benefits. More than three-fourths (77 percent) of the respondents believe it is critical to preserve Social Security even if it means increasing taxes. In addition, Americans strongly support improving Social Security for particularly vulnerable groups. For example, 76 percent support improving the benefits for widowed spouses of low-income working couples who generally have inadequate benefits from lifelong low-pay work. • Americans want Congress to act to keep Social Security solvent and guarantee the benefits. The vast majority (90 percent) of Americans believe it is important for Congress to make adjustments in the next two years to keep Social Security financially solvent and guarantee the benefits for retirees, people with disabilities, and children and widowed spouses of deceased workers.

Getting Your Money’s Worth One of the most controversial and complex issues in the Social Security program is whether workers and families receive their money’s worth in terms of benefits received and payroll taxes paid. Many conservative politicians and certain organizations have strongly supported proposals for the partial privatization of Social Security. They argue that the real return on Social Security tax contributions is relatively low, and that workers should be allowed to invest part of their payroll tax contributions in personal retirement accounts and earn substantially higher returns. In particular, many younger workers believe the Social Security program is a “bad buy” because the value of the benefits received will be less than the value of the taxes paid. The Office of Chief Actuary in the Social Security Administration periodically calculates the theoretical money’s worth ratios for hypothetical worker with various earnings patterns and levels under the Social Security program.22 The money’s worth ratio is defined as the ratio of present value of expected benefits to the present value of expected payroll taxes (tax contributions) for an individual or a cohort of workers. A ratio value greater than one indicates that, on a present value basis, more money

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is expected to be received in benefits than is expected to be paid in payroll taxes over the lifetime of that individual or cohort. A ratio value of less than one indicates the opposite effect. The methodology compares the scheduled future benefits for a group of workers and their dependents with the amount that would be payable if their payroll tax contributions were invested at a given interest rate or set of interest rates. In other words, would the particular individual or group get its “money’s worth”?

Methodology and Assumptions The money’s worth ratios are calculated for individual workers and families based on earning patterns, date of birth, gender, and marital status under different economic scenarios. We discuss here only the money’s worth ratios under the scheduled benefits and taxes under present law. The Social Security actuaries have made a number of assumptions in the study: workers are assumed to start working at age 21; the maximum earner pays payroll taxes on the maximum taxable wage base each year starting at age 22; the wife and husband of each couple are assumed to be the same age; finally, marriage is assumed to occur on the joint 22nd birthday of the husband and wife, and two children are assumed. In the calculation of the present value of expected payroll taxes, the total OASDI tax is counted, and both employer and employee payroll taxes are counted. Finally, the analysis considers all types of retirement, disability, and survivor benefits (except benefits to student children, disabled adult children, and parents caring for a disabled adult child). Mortality rates, disability incidence rates, and termination rates are considered in the computations. Considering all types of benefits is a great improvement over earlier research studies that tended to focus solely on retirement benefits and considered only the OASI portion of the total OASDI tax.

Empirical Results Table 6.1 presents the money’s worth ratios under present law for five different workers with different career-average earnings levels and marital statuses. The assumed earnings levels are as follows: Very Low Low Medium High Maximum

($9,662) ($17,393) ($38,651) ($61,842) ($85,885)

Single males who have very low or low earnings generally have favorable money’s worth ratios of one or higher, which highlights the value of the Social Security program in providing income to beneficiaries with low earnings. However, single males with medium, high, and maximum earnings have ratios under one, except single males born in 1920, albeit relatively few beneficiaries in that age group are still alive.

Getting Your Money’s Worth  139 Table 6.1

Money’s Worth Ratios for Various Earning Level Scaled Workers OASDI Program—Present Law Scheduled Scenario (Percent) Earnings level

Very Low

Low

Medium

High

Maximum

Year of Birth

Year attains age 65

Single male

Single female

One-earner couple

Two-earner couple

1920 1930 1937 1943 1949 1955 1964 1973 1985 1997 2004 1920 1930 1937 1943 1949 1955 1964 1973 1985 1997 2004 1920 1930 1937 1943 1949 1955 1964 1973 1985 1997 2004 1920 1930 1937 1943 1949 1955 1964 1973 1985 1997 2004 1920 1930 1937 1943 1949 1955 1964 1973 1985 1997 2004

1985 1995 2002 2008 2014 2020 2029 2038 2050 2062 2069 1985 1995 2002 2008 2014 2020 2029 2038 2050 2062 2069 1985 1995 2002 2008 2014 2020 2029 2038 2050 2062 2069 1985 1995 2002 2008 2014 2020 2029 2038 2050 2062 2069 1985 1995 2002 2008 2014 2020 2029 2038 2050 2062 2069

2.46 1.51 1.36 1.22 1.25 1.31 1.42 1.52 1.57 1.60 1.63 1.96 1.11 0.99 0.89 0.91 0.96 1.04 1.11 1.15 1.17 1.19 1.35 0.82 0.74 0.66 0.67 0.71 0.77 0.82 0.85 0.87 0.88 1.21 0.71 0.62 0.55 0.56 0.59 0.64 0.68 0.70 0.72 0.73 1.10 0.64 0.56 0.48 0.46 0.45 0.47 0.51 0.52 0.53 0.54

3.02 1.76 1.55 1.37 1.41 1.48 1.60 1.71 1.73 1.76 1.79 2.41 1.29 1.13 1.00 1.02 1.08 1.17 1.25 1.27 1.29 1.30 1.65 0.95 0.84 0.74 0.76 0.80 0.86 0.92 0.94 0.95 0.96 1.48 0.83 0.71 0.61 0.63 0.66 0.72 0.77 0.78 0.79 0.80 1.33 0.74 0.63 0.53 0.52 0.50 0.53 0.57 0.58 0.58 0.59

5.48 3.22 2.82 2.47 2.47 2.54 2.65 2.77 2.79 2.82 2.85 4.34 2.37 2.07 1.80 1.81 1.86 1.94 2.03 2.05 2.07 2.09 3.00 1.78 1.56 1.36 1.36 1.39 1.45 1.52 1.53 1.54 1.56 2.68 1.55 1.31 1.12 1.12 1.16 1.20 1.26 1.27 1.28 1.30 2.42 1.37 1.17 0.97 0.92 0.88 0.89 0.94 0.94 0.95 0.96

2.86 1.75 1.59 1.41 1.41 1.46 1.56 1.66 1.69 1.72 1.74 2.28 1.30 1.17 1.03 1.03 1.07 1.15 1.23 1.25 1.27 1.29 1.56 0.96 0.87 0.77 0.77 0.80 0.86 0.91 0.93 0.94 0.96 1.40 0.84 0.73 0.64 0.64 0.66 0.71 0.76 0.77 0.79 0.80 1.26 0.74 0.65 0.55 0.52 0.51 0.53 0.57 0.58 0.58 0.59

Source: Social Security Administration.

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Single females at every age group have higher money’s worth ratios than single males. This result occurs because females have a higher life expectancy than males, not because of higher benefits. Single females with very low or low earnings also have favorable ratios exceeding one, which again highlights the value of Social Security in providing income to low-income earners. However, single females with medium, high, and maximum earnings have ratios under one, except single females born in 1920. Married couples with one earner have favorable money’s worth ratios at all age groups, except maximum earners born in 1943 or later. The ratios are higher than the ratios for single earners, which again show the value of Social Security in protecting the family. Married couples with two earners overall have lower money’s worth ratios than families with one earner. However, two-earner couples with very low or low earnings have ratios exceeding one. Families with two earners who have medium, high, or maximum earnings have ratios under one, except for beneficiaries born in 1920.

Evaluation of Money’s Worth Argument Even if the money’s worth ratio for a particular age group is under one, it does not necessarily follow that the Social Security program overall is a “bad buy” for these beneficiaries. Other important factors must be considered. First, Social Security benefits can eliminate or substantially reduce the financial support required of children to support their aged parents if the Social Security program did not exist; the benefits paid also have a powerful impact on reducing aged poverty. Second, the Social Security program is one of the few defined-benefit plans in existence today that covers the vast majority of workers. Defined-benefit pension plans are plans that pay guaranteed benefits to retired workers. Private definedbenefit plans have declined in relative importance, and most employees today do not participate in such plans. A small percentage of workers participate only in definedbenefit plans while others participate in both defined-benefit and defined-contribution plans. According to the Employee Benefit Research Institute (EBRI), 3 percent of all private-sector workers participated only in defined-benefit plans in 2008. Another 12 percent of all private-sector workers participated in both defined-benefit and definedcontribution plans.23 In contrast, about 93 percent of workers in paid employment and self-employment are covered under the Social Security program. Third, unlike most private defined-benefit pension plans, the Social Security benefits are automatically adjusted for inflation each year based on measurable changes in the consumer price index. As a result, real income is maintained, which enhances the economic security of retired beneficiaries. Fourth, the value of the insurance protection for survivors and for disabled workers is substantial. The public generally is unaware of the significant value of OASDI survivor benefits. According to the National Academy of Social Insurance, the value of Social Security survivor benefits in terms of private life insurance equivalents is $433,000 for an average married worker, age 30, with two children.24 The value of disability income benefits is also substantial. According to the National Academy of

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Social Insurance, Social Security disability benefits are the equivalent of a $414,000 disability income policy purchased in 2006. This amount represents the total benefits available to a married worker, age 30, with two children, who becomes disabled after earning between $25,000 and $30,000 annually.25 In addition, the money’s worth ratios are only theoretical indicators of the apparent value of the contributions paid by an individual worker or cohort group. The real value of the benefits under a social insurance program is the amount paid to beneficiaries each year compared with the total cost, or resources used up, of providing the benefits. The present Social Security program has razor-thin administrative expenses and is a real bargain when compared to private retirement products. Current OASDI administrative expenses are only about 1 percent of total program costs. As a result, the real value of the Social Security program is extraordinarily high.26 Private retirement plans have significantly higher administrative costs. Finally, an analysis of getting your money’s worth is largely irrelevant when two additional factors are considered. First, the Social Security program is not an individual personal investment program but is a compulsory public income maintenance program that provides a base of income protection to most of the population. The Social Security program was never intended to provide equal financial benefits to all beneficiaries. Instead, the benefit structure is intentionally skewed to favor certain groups for social adequacy reasons, such as low-income groups and large families. As such, these groups have much higher money’s worth ratios when compared with other groups. Thus, an analysis of getting your money’s worth for an individual worker, while an interesting theoretical exercise, is largely irrelevant in terms of the social goals and objectives of the Social Security program. Second, the Social Security payroll tax can be viewed as a tax for the common good of society. As is true of any tax, some people will benefit from a specific tax while others will lose. For example, a single homeowner with no children does not directly benefit from the property taxes on his or her home that support the local schools. In contrast, a homeowner with several children in school receives substantially greater financial benefits from the property taxes paid. The property tax paid by the single homeowner, however, can be viewed as a tax paid for the common good of education. Likewise, in a broader sense, the Social Security payroll tax can be viewed as an earmarked tax that benefits the common good for society. Thus, a money’s worth analysis for an individual worker is largely irrelevant. In conclusion, most workers will get their money’s worth when the entire program is considered, especially during periods of severe economic downturn. The Social Security program proved its enormous value and worth during the recent financial meltdown and severe economic downswing in 2008 and 2009. At the time of writing, a large number of private defined-benefit pension plans are substantially underfunded because of the loss of billions of dollars during the severe stock market decline, the market collapse in real-estate prices, and huge losses on other investments that occurred during this period. In contrast, the Social Security program did not experience any investment losses because excess trust fund revenues are invested in special issues of the United States Treasury that are guaranteed against loss and redeemable at face value any time funds are needed.

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Reducing Social Security Payroll Taxes to Stimulate the Economy Another timely issue is whether the Social Security payroll tax should be reduced during recessions to stimulate the economy. In 2008 and 2009, the American economy experienced the second worst economic downswing in its history, next only to the Great Depression of the 1930s. To stimulate the economy, Congress considered a wide variety of spending and tax options, including a reduction in the Social Security payroll tax for both employers and employees to stimulate the economy.

Employers’ Payroll Tax One option was a temporary reduction in the Social Security payroll tax paid by employers, to encourage firms to hire unemployed workers and thus stimulate the economy. Under the proposal, employers who increased their payrolls in 2010 over 2009 would receive a one-year, nonrefundable income tax credit against their payroll tax liability. The Congressional Budget Office (CBO) analyzed the economic effects of the proposal and concluded that firms would respond to a temporary payroll tax reduction through a combination of four channels. 27 • Some firms would respond to lower labor costs by reducing the prices of the goods and services they sell. Increased sales in turn would stimulate production, which would then increase the number of hours worked and the number of new workers hired. • Some firms would pass the payroll tax savings on to employees in the form of higher wages or other forms of compensation, which would in turn encourage more spending by those employees. However, wages generally are inflexible in the short run because of negotiation and administrative costs, so that response is not likely to be very large. • Some firms would retain the tax savings as profits, which would increase cash flow and enable firms with borrowing constraints to buy new equipment. Also, higher profits could increase the firms’ common stock prices. The resulting higher household wealth might encourage additional consumption, although shareholders are likely to spend only a small part of their gains. • Some firms may use slightly more labor during a period when it was temporarily less expensive. Depending on the type of products made, some firms would increase their use of labor that was temporarily less expensive while the policy was in effect and reduce the use of labor later. CBO concluded that reducing employers’ payroll taxes would raise output (gross national product) cumulatively between 2010 and 2015 by $0.40 to $1.30 for each dollar of total budgetary cost. Congress did not enact the proposal analyzed by the CBO in its exact form. Instead, it enacted the Hiring Incentives to Restore Employment (HIRE) Act in March

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2010, which provided payroll tax incentives to eligible employers to hire unemployed workers. The act provided two new tax benefits to encourage employers to hire previously unemployed workers. First, employers received a payroll tax exemption of 6.2 percent on the employer’s portion of the Social Security tax on wages paid to qualifying employees from March 19, 2010, through December 31, 2010. Second, for each qualified employee retained for at least 52 consecutive weeks, employers received a tax credit of 6.2 percent on the wages paid to a qualified employee over a 52-week period up to a maximum of $1,000. The tax incentives in the HIRE Act expired at the end of 2010.

Employees’ Payroll Tax CBO also analyzed the economic impact on output and employment of a temporary reduction in the employees’ portion of the Social Security payroll tax. The tax reduction would increase take-home pay and would stimulate additional spending by households that received the higher income. As such, increased spending would increase production and employment. CBO believes that these effects, however, would be spread over time, and that the majority of the increased take-home pay would be saved rather than spent. CBO concluded that a reduction in employees’ payroll taxes would increase output cumulatively between 2010 and 2015 by $0.30 to $0.90 for each dollar of total budgetary cost.28 As such, the stimulus effect would be lower than an equivalent reduction in employer payroll taxes. In late 2010, Congress enacted legislation extending the Bush-era tax cuts that were scheduled to expire at the end of 2010. The tax package included a provision for a temporary payroll tax holiday by which the employee’s portion of the OASDI tax would be reduced from 6.2 percent to 4.2 percent for calendar year 2011 to stimulate the economy and reduce unemployment. The one-year payroll tax cut of 2 percent would cost $120 billion. The federal government would replace the lost revenue to the OASDI trust fund out of its general revenues. The temporary payroll tax cut has both advantages and disadvantages as a stabilizing tool. Advantages include the following: • The vast majority of workers pay OASDI taxes. The payroll tax cut is widespread across the entire economy, which quickly increases consumer spending and tends to reduce unemployment. In contrast, specifically earmarked federal expenditures, such as spending on new bridges, roads, and infrastructure, are much slower to implement, and the economic effects on unemployment are more localized and not spread widely throughout the entire economy. • In 2009, 47 percent of American households paid no personal income taxes. A cut in the payroll tax gives these workers a significant increase in take-home pay, which promotes greater spending throughout the economy. • The payroll tax cut enhances personal economic freedom on how to spend the additional income since disposable personal income is higher, and workers, not the government, make the decision on how to spend the money.

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The OASDI payroll tax cut has several disadvantages, however. They include the following: • The payroll tax cut violates an important historical principle of the OASDI program that has been consistently followed by Congress, which states the program should be financially self-supporting without substantial infusion of general revenues of government. The Social Security program is faced with serious financial problems in the near-term future. If the lost revenue is not replaced, the program’s financial position will worsen even more. • As stated earlier, the federal government must reimburse the OASDI trust fund for the lost revenue out of general revenues. However, the government has no excess general revenues and will instead have to borrow the money. As a result, the federal deficit will be substantially increased. • The temporary payroll tax reduction may be psychologically upsetting to workers if the payroll tax is increased after one year because the workers’ take-home pay will be less. • The unemployment rate may still be high and substantially above the fullemployment rate when the temporary tax holiday expires at the end of 2011. A payroll tax increase can reduce consumer spending and slow the recovery.

Evaluation of Payroll Taxes as a Countercyclical Tool Although policymakers must consider the long-run fiscal impact of the Social Security program, it is questionable whether OASDI tax rates, benefits, and the earnings base should be frequently changed because of short-run countercyclical considerations. The late Robert J. Myers, former chief actuary of the Social Security Administration, opposed using the OASDI payroll tax as a countercyclical tool for several reasons. Although he pointed out the dangers of using OASDI taxes as a countercyclical tool more than 40 years ago, his arguments are still relevant today.29 First, proper financing of the program may be jeopardized by adjusting the payroll tax for countercyclical reasons. It is argued that a financially sound social insurance program must have a definite plan for the financing of benefits, and arbitrary changes in tax rates for fiscal policy purposes could seriously weaken its financial soundness. For example, if a severe recession requires the reduction of Social Security payroll taxes over an extended period, there may be insufficient revenues for maintaining the financial solvency of the program without government assistance. Also, frequent adjustment of payroll tax rates upward and downward might be psychologically disturbing to covered employers and employees, and the uncertainty would make it more difficult for employers to make rational business decisions that affect labor costs. Second, payroll taxes are difficult to adjust upward and downward with great speed. Congress is slow to enact tax increases, and even tax reductions take a considerable amount of time to enact. Thus, timely adjustment of OASDI tax rates to business cycle conditions might not be possible for the adjustment to be effective, and the impact on unemployment might be reduced. Finally, if payroll taxes are reduced during a business recession, and the OASDI

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trust fund is reimbursed for the loss of tax revenues out of the general revenues of the federal government, the economic effects are not neutral. At the present time, the federal government is experiencing historically high annual budgetary deficits. As stated earlier, the federal government will have to borrow money to reimburse the OASDI for the loss of revenue. This could lead to an undesirable “crowding out effect” of private investment. A substantial increase in government borrowing would increase interest rates, and private investment would be adversely affected. Also, increased government borrowing would absorb funds in the private sector that would otherwise be available for new economic investments. As a result, capital accumulation would be reduced. In addition to the previously mentioned problems, the Social Security program is faced with serious financial problems in the near-term future. The financing problems are discussed in Chapter 7.

Summary • A higher full retirement age has been proposed because life expectancy has increased. However, the increase in life expectancy is not uniform among all groups. Low-wage workers, blacks, and Native Americans have experienced slower increases in longevity. As a result, these groups may be harmed by a higher retirement age. • A higher full retirement age would increase the period of productive earnings and enable workers to accumulate higher retirement savings. • The long-range actuarial deficit would be substantially reduced by a higher full retirement age. • Opponents of a higher retirement age present several counter-arguments. A higher full retirement age will reduce benefits for all income groups at retirement; a higher retirement age may be harmful to minority workers and other low-income workers; older workers with health problems may be harmed; job and promotion opportunities for younger workers may be reduced; and impaired workers under the full retirement age may have an increased incentive to file for disability benefits. • The adequacy of Social Security benefits depends on the measure of adequacy used. These measures include poverty thresholds, replacement rates, the extent to which vulnerable groups are protected, and the extent to which Social Security benefits keep people off welfare. • Social Security net replacement rates will decline in the future because of the increase in the full retirement age, which amounts to a cut in benefits at every age; higher Medicare premiums, which reduce the amounts that retired beneficiaries can spend; and the larger proportion of beneficiaries who will be taxed on their benefits. • Social Security retirement benefits may be inadequate for certain vulnerable groups, which include widows age 65 and over who live alone, long-service workers employed at minimum wage or low wages, and beneficiaries age 80 or older.

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• The National Retirement Risk Index shows that a large proportion of workers will be unable to maintain their present standard of living after they retire. • The Social Security disability income program has several significant problems and issues. These include the large backlog of pending claims, the high proportion of initial claims denied, the appropriateness of the current definition of disability, and the recent work test requirement. • Many disability claims are denied because the applicants do not meet the strict definition of disability in the Social Security program and are considered capable of working in substantial gainful activity. Other claims are denied because the applicants are not disability insured, do not meet the recent work test requirement, or fail to meet other eligibility requirements. • The claims process is lengthy, and disabled persons must often wait one year or longer to receive benefits. As a result, they may experience considerable economic insecurity during the interim period. • The present definition of disability may be inappropriate in view of medical and technological advances that enable some disabled beneficiaries to work; the process of collecting benefits can be slow and demanding; benefits may be terminated if work earnings exceed certain limits; and the present definition may impose a severe hardship on older disabled beneficiaries. • The recent work test requirement to collect disability benefits may be inequitable to women age 31 and older who are forced to drop out of the labor force to care for dependent children or aged parents, and to workers whose working ability has been gradually reduced because of a progressive impairment. Some disabled workers fail to qualify for benefits because of the work test requirement even though they have paid into the program for a long time. • According to a recent poll, the majority of Americans currently support Social Security and would prefer to pay high tax rates rather than experience a cut in benefits. • The money’s worth ratio is defined as the ratio of present value of expected benefits to the present value of expected payroll taxes (tax contributions) for an individual or a cohort of workers. A ratio value of one or higher indicates that, on a present value basis, more money is expected to be received in benefits than is expected to be paid in payroll taxes over the lifetime of that individual or cohort. A ratio value under one indicates the opposite effect. • Even if the money’s worth ratio is under one for an age group, it does not mean that the Social Security program is a “bad buy” when the entire program is considered. Social Security benefits can eliminate or reduce the financial support required of children to support their aged parents; the benefits have a powerful impact on reducing aged poverty; the Social Security program is one of the few defined-benefit plans in existence that covers most workers; unlike most private pension plans, the Social Security benefits are automatically adjusted for inflation each year; the value of the insurance protection for survivors and for disabled workers is substantial; and the real value of the Social Security program is extraordinarily high because the administrative costs of providing benefits are about 1 percent.

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• Reducing Social Security taxes to stimulate the economy during business downswings presents several problems. A financially sound social insurance program must have a definite plan for the financing of benefits, and arbitrary changes in tax rates for fiscal policy purposes could seriously weaken its financial soundness; payroll taxes are difficult to adjust upward and downward with great speed; and the federal government would have to borrow the money to reimburse the trust funds for the loss of revenue, which could lead to an undesirable “crowding out effect” of private investment.

Review Questions 1. Explain the arguments for and against a higher full retirement age. 2. How do Social Security retirement benefits measure up in terms of replacement rates? 3. Are Social Security retirement benefits adequate for aged widows? Explain your answer. 4. Explain whether Social Security benefits are adequate for the following groups: a. Long-service workers employed at low wages b. Beneficiaries age 80 or older 5. Why will Social Security replacement rates decline in the future? 6. Explain the reasons for the high denial rate for initial disability income claims. 7. Explain the definition of disability in the current Social Security program. Identify the problems in the application of this definition to disabled ­workers. 8. Describe the attitudes of Americans toward the Social Security program. 9. Evaluate the viewpoint that many workers do not receive their money’s worth under the Social Security program. 10. Explain the proposal for reducing the Social Security payroll tax to stimulate output and employment.

Application Questions 1. A critic of the current Social Security program stated, “Social Security retirement benefits are more than adequate because the average Social Security retirement benefit is substantially above the poverty threshold.” a. Do you agree or disagree with the above statement? Explain your ­answer. b. Explain some additional techniques that can be used to measure the adequacy of Social Security benefits. c. Identify the groups for which retirement benefits may be inadequate. 2. The Social Security Administration periodically calculates a number of hypothetical money’s worth ratios for an individual worker or cohort of workers based on earnings, year of birth, gender, and marital status. a. What is the money’s worth ratio? b. Identify the groups that have (i) favorable and (ii) unfavorable money’s worth ratios.

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c. If the money’s worth ratio is less than one for an individual worker or cohort of workers, does this mean that the Social Security program is a “bad buy”? Explain your answer.

Internet Resources • The Center for Retirement Research at Boston College provides cutting-edge research studies on retirement issues, Social Security, and other topics dealing with economic security. The goals of the center are to promote research on retirement issues, to transmit new findings to the policy community and the public, to help train new scholars, and to broaden access to valuable data sources. Visit the site at http://crr.bc.edu • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on Social Security and Medicare on its Web site. Visit the site at www.nasi.org • The National Commission to Preserve Social Security & Medicare has the goal to protect, preserve, promote, and ensure the financial security, health, and well-being of current and future generations of older Americans. The organization issues timely articles and studies on the current Social Security and Medicare programs. Visit the site at www.ncpssm.org • Social Security Online is the official Web site for the Social Security Administration, which administers the Social Security (OASDI) program in the United States. The site provides updated information on retirement, survivor, and disability benefits, and recent changes in the program. Visit the site at www.socialsecurity.gov • The Office of the Chief Actuary in the Social Security Administration provides actuarial cost estimates of the OASDI program and determines the annual cost-ofliving adjustments in benefits. The site provides a number of timely publications. Visit the site at www.socialsecurity.gov/OACT • The Social Security Advisory Board advises the president and Congress on issues relating to the Social Security program in the United States. The site provides timely and relevant reports dealing with Social Security. Visit the site at www.ssab.gov

Selected References American Academy of Actuaries. Raising the Retirement Age for Social Security, Issue Brief, October 2010. ———. Social Security Reform Options. Public Policy Monograph, January 2007. Biggs, Andrew G., and Glenn R. Springstead. “Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income.” Social Security Bulletin 68, no. 2 (2010). Congressional Budget Office. “CBO’s Assessment of a Policy Option to Reduce Employers’ Payroll Taxes for Firms That Increase Their Payroll.” Letter from Douglas W. Elmendorf, Director, to Honorable Robert P. Casey, Jr., United States Senate, February 3, 2010. ———. Policies for Increasing Economic Growth and Employment in 2010 and 2011. Washington, DC, January 2010. ———. Policies for Increasing Economic Growth and Employment in the Short Term. Statement of Douglas W. Elmendorf, director, prepared for the Joint Economic Committee, U.S. Congress, February 23, 2010.

Notes  149 Munnell, Alicia, Anthony Webb, and Francesca Golub-Sass. “The National Retirement Risk Index: After the Crash.” Center for Retirement Research at Boston College, no. 9–22, October 2009. National Academy of Social Insurance. “The Role of Benefits in Income and Poverty.” Social Security at www.nasi.org. This is an online source book that is periodically updated to highlight key facts about Social Security. Office of the Chief Actuary. Social Security Administration. “Money’s Worth Ratios Under the OASDI Program for Hypothetical Workers.” Actuarial Note, no. 2008.7, April 2009. Social Security Advisory Board. Social Security: Why Action Should Be Taken Soon. December 2010. Special Committee on Aging. United States Senate. Social Security Modernization: Options to Address Solvency and Benefit Adequacy. Report of the Special Committee on Aging, United States Senate, May 2010. Strengthening Social Security for Vulnerable Groups. National Academy of Social Insurance, 2009. Reno, Virginia, and Joni Lavery. Economic Crisis Fuels Support for Social Security: Americans’ Views on Social Security. National Academy of Social Insurance, August 2009. ———. Fixing Social Security: Adequate Benefits, Adequate Financing. National Academy of Social Insurance, October 2009. ———. Social Security and Retirement Income Adequacy. National Academy of Social Insurance, Social Security Brief no. 25, May 2007. ———. When to Take Social Security Benefits: Questions to Consider. National Academy of Social Insurance, Social Security Brief no. 31, January 2010. Rockeymoore, Maya, and Melissa Maitin-Shepard. Tough Times Require Strong Social Security Benefits: Views on Social Security Among African Americans, Hispanic Americans, and White Americans. National Academy of Social Insurance, Social Security Brief no. 32, February 2010. Rosenblatt, Robert. Social Security: An Essential Asset and Insurance Protection for All. National Academy of Social Insurance, Social Security Brief no. 26, February 2008. Sass, Steven A. “The Research Contributions of the Center for Retirement Research at Boston College.” Social Security Bulletin 69, no. 4 (2009). Scholz, John Karl, and Ananth Seshadri. “What Replacement Rates Should Households Use?” Michigan Retirement Research Center, University of Michigan, Working Paper, September 2009. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office, 2011. United States Government Accountability Office. “Retirement Income: Challenges for Ensuring Income Throughout Retirement.” GAO-10-632 Retirement Income. Washington, DC, April 28, 2010.

Notes 1. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2011), Table V.A4, p. 91. 2. American Academy of Actuaries, Raising the Retirement Age for Social Security. Issue Brief, October 2010. 3. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2011), p. 3. 4. Social Security Advisory Board, Social Security: Why Action Should Be Taken Soon. December 2010, Option 17, p. 27. 5. Social Security Administration, Income of the Aged Chartbook, 2008 (Washington, DC: Office of Retirement and Disability Policy and Office of Research, Evaluation, and Statistics, April 2010), p. 9.

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6. Paul N. Van de Water and Arloc Sherman, Social Security Keeps 20 Million Americans Out of Poverty: A State-by-State Analysis. Center on Budget and Policy Priorities, August 11, 2010. 7. See Virginia Reno and Joni Lavery, Fixing Social Security: Adequate Benefits, Adequate Financing. National Academy of Social Insurance, October 2009, pp. 1–2. 8. The 2010 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2010), Table VI.F10. 9. Virginia Reno and Joni Lavery, Social Security and Retirement Income Adequacy. National Academy of Social Insurance, Social Security Brief no. 25, May 2007, p. 3. 10. Bureau of Labor Statistics, U.S. Department of Labor, Employee Benefits in the United States, March 2010. News release, July 27, 2010, Table 1. 11. Steven A. Sass, “The Research Contributions of the Center for Retirement Research at Boston College.” Social Security Bulletin 69, no. 4 (2009): 39. 12. Reno and Lavery, Social Security and Retirement Income Adequacy, p. 10. 13. Reno and Lavery, Fixing Social Security: Adequate Benefits, Adequate Financing, p. 9. 14. American Academy of Actuaries, Social Security Reform Options. Public Policy Monograph, January 2007, p. 16. 15. Social Security Administration, Income of the Population 55 or Older (Washington, DC: Office of Retirement and Disability Policy and Office of Research, Evaluation, and Statistics, April 2010), Table 2.A1. 16. National Retirement Risk Index. Available at http://crr.bc.edu/special_projects/national_retirement_risk_­index.html 17. Social Security. “Social Security Hearings Backlog Falls to Lowest Level Since 2005.” News release, March 2, 2010. 18. Social Security Administration, Office of Research, Evaluation, and Statistics, Annual Statistical Report on the Social Security Disability Insurance Program, 2009, Table 59. 19. U.S. Government Accountability Office, Social Security Disability: SSA Must Hold Itself Accountable for Continued Improvement in Decision-Making. HEHS-97–102, August 12, 1997. 20. U.S. Government Accountability Office, SSA Disability Programs: Fully Updating Disability Criteria Has Implications for Program Design. GAO-02–919T, July 2002. 21. Virginia Reno and Joni Lavery, Economic Crisis Fuels Support for Social Security: Americans’ Views on Social Security. National Academy of Social Insurance, August 2009. 22. Office of the Chief Actuary, Social Security Administration, “Money’s Worth Ratios Under the OASDI Program for Hypothetical Workers.” Actuarial Note, No. 2009.7, July 2010. 23. Employee Benefit Research Institute, “What Are the Trends in U.S. Retirement Plans?” FAQs About Benefits—Retirement Issues, Retirement Question 14, Figure 1. 24. Robert Rosenblatt, Social Security: An Essential Asset and Insurance Protection for All. National Academy of Social Insurance, Social Security Brief no. 26, February 2008. 25. Ibid. 26. Office of the Chief Actuary, Social Security Administration, “Money’s Worth Ratios Under the OASDI Program for Hypothetical Workers.” Actuarial Note, No. 2008.7, April 2009. 27. Congressional Budget Office, “CBO’s Assessment of a Policy Option to Reduce Employers’ Payroll Taxes for Firms That Increase Their Payroll.” Letter from Douglas W. Elmendorf, Director, to Honorable Robert P. Casey, Jr., United States Senate, February 3, 2010. 28. Congressional Budget Office, Policies for Increasing Economic Growth and Employment in the Short Term. Statement of Douglas W. Elmendorf, Director, prepared for the Joint Economic Committee, U.S. Congress, February 23, 2010. 29. Robert J. Myers, “The Past and Future of Old-Age, Survivors, and Disability Insurance.” In The Princeton Symposium on the American System of Social Insurance: Its Philosophy, Impact, and Future Development, ed. William G. Bowen, Frederick H. Harbison, Richard A. Lester, and Herman M. Somers (New York: McGraw-Hill, 1968).

7 Financing the Social Security Program

Student Learning Objectives After studying this chapter, you should be able to: • Explain the financing principles that are followed in the Social Security program. • Describe the nature and purposes of the Social Security and Medicare trust funds. • Explain how the trust funds are invested. • Explain the short-range and long-range financial condition of the Social Security and Medicare programs. • Explain several proposals for reducing the long-term Social Security actuarial deficit. The Social Security program is the major economic security program for most Americans, and it must be soundly financed to pay promised benefits. In this chapter, we discuss the financing principles and financial operations of Social Security and Medicare; the nature, purposes, and investments of the trust funds; and the current financial condition of Social Security and Medicare. The chapter concludes with a discussion of proposed solutions to the long-range Social Security actuarial deficit.

Methods of Financing A number of methods can be used to finance the Social Security program. One approach is pay-as-you go financing, a scheme by which scheduled taxes produce the amount of income needed to pay current benefits, a large trust fund is not built up, and trust fund assets are accumulated only to the extent necessary to prevent exhaustion of the fund by random economic fluctuations. A second approach is full advance funding. According to Social Security actuaries, full advance funding is a financing scheme by which contributions are established to pay the full cost of future benefits as these costs are incurred for 151

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each year of current service. This method also provides for the amortization over a fixed period of any past service benefits based on service with the firm prior to establishment of the plan.1 Under full advance funding, all benefits are paid for or are financed during the years prior to their receipt. When added to the investment income, contributions into the fund are sufficient for paying all guaranteed or promised benefits. A final approach is partial advance funding, in which scheduled taxes produce a substantial accumulation of trust fund assets that generate additional interest income and reduce the need for payroll tax increases during periods when costs are relatively high. The trust fund buildup under partial advance funding is much smaller than it would be with full advance funding.2 The Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI) trust funds are currently financed based on partial advance funding.3 However, the program is much closer to a pay-as-you go plan than to a fully funded plan. This is because the Old-Age, Survivors, and Disability Insurance (OASDI) Trust Fund assets totaled slightly more than $2.6 trillion at the end of 2010, which represents the accumulated excess of income over expenditures under the Social Security program. However, at the time of writing and based on current law, the program will operate on a pay-asyou go basis once the trust funds are exhausted (around 2036). After the trust funds are exhausted, benefits would be reduced to match taxable income unless Congress enacts financing reforms prior to that date.

No Full Funding The OASDI program is not fully funded; that is, full advance funding is not presently followed. A fully funded program is considered unnecessary for several reasons. First, the program is expected to continue indefinitely and will not terminate in the predictable future. Second, since the program is compulsory, new entrants will always enter the program and pay taxes to support it. Third, the taxing and borrowing powers of the federal government can be used to raise additional revenues if the program has financial problems. Finally, from an economic viewpoint, full funding is undesirable as it would require substantially higher payroll taxes for many years, which could be deflationary and cause substantial unemployment. In contrast, private defined-benefit pension plans must emphasize full advance funding since defined pension plans can and do terminate. Thus, to protect the pension rights of active and retired workers, private defined-benefit plans typically emphasize full advance funding.

Actuarially Sound Program Congress has consistently indicated that the Social Security program should be actuarially sound. This is important because Social Security is the major economic security program for most Americans, and if it fails to provide the promised benefits, economic security could be threatened. At the time of this writing, however, the Social Security program is not in actuarial

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balance over a 75-year projection period. According to the 2011 report by the Board of Trustees, the Social Security program is expected to experience a serious long-range actuarial deficit of 2.22 percent of taxable payroll over a 75-year projection period, up from 1.92 percent projected in the 2010 report. The financial condition of the Social Security program is discussed in greater detail later in the chapter.

Social Security Trust Funds Nature of the Trust Funds There are four separate Social Security trust funds.4 The Old-Age and Survivors Insurance (OASI) Trust Fund pays retirement and survivors’ benefits; the Disability Insurance (DI) Trust Fund pays disability benefits. Both OASI and DI are often considered on a combined basis (OASDI). In addition, for Medicare Part A, the Hospital Insurance (HI) Trust Fund pays for inpatient hospital care and related services. The Supplementary Medical Insurance (SMI) Trust Fund comprises two separate accounts: (1) Part B, which pays for physician and outpatient services, and (2) Part D, which covers prescription drug benefits. All Social Security and Medicare payroll tax contributions, premiums, and other sources of income are credited to the funds. Disbursements from the trust fund can be made only to pay benefits and program administrative costs. All excess funds must be invested in interest-bearing securities backed by the full faith and credit of the United States.

Purposes of Trust Funds The trust funds have several purposes. First, the trust funds provide an accounting method for recording all income to and disbursements from the funds. Second, the trust funds hold the accumulated assets. These assets provide automatic spending authority to pay benefits; as stated earlier, disbursements are limited to benefits and administrative costs. Third, the trust funds provide some interest income that reduces the program’s cost. Finally, the trust funds are available as contingency reserves to help meet any deficiency in contribution income during periods of economic recessions or demographic changes when outgo might exceed income.

Investments of Trust Funds The excess of trust fund income over outgo is invested in securities that are guaranteed as to both principal and interest by the federal government. All securities held by the trust funds are “special issues” of the U.S. Treasury available only to the trust funds. Unlike marketable Treasury securities that are available to the general public, special issues can be redeemed any time at face value. In contrast, marketable Treasury securities are subject to market fluctuations, which can result in either profit or loss. The trust fund investments in special issues, however, are redeemable at face value and provide the same flexibility as holding cash. Thus, the special issues are guaranteed against loss.

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Interest Rate on Trust Fund Assets

The trust funds earn interest on the accumulated assets. The interest rate on special issues is determined by a formula enacted in 1960 in which the interest rate is determined at the end of each month and applies to new investments the following month. In 2010, the numerical average of the 12 monthly interest rates was 2.76 percent. However, in 2010, the effective annual interest rate (average rate of return in all investments over a one-year period) for the combined OASI and DI trust funds was 4.64 percent. The higher effective rate is due to special-issue bonds that the trust funds acquired in previous years when interest rates were higher. Tax Contributions

The OASDI program is financed largely from dedicated (earmarked) tax contributions, investment income on trust fund assets, and revenues from the partial taxation of Social Security benefits. Tax contributions are deposited on a daily basis and are invested in special-issue securities of the U.S. Treasury. The cash received by the Treasury goes into the Treasury’s general fund and is indistinguishable from other cash in the fund. Money needed to pay benefits and administrative expenses comes from the redemption or sale of securities held by the trust funds. When the specialissue securities are redeemed, interest is paid. The principal amount of special issues redeemed, plus the interest paid, is just enough to cover the expenditure made. In 2010, the amount of securities purchased by the trust funds totaled $1,020 billion, while the amount sold was $929 billion. Trust Fund Assets Not Worthless

Critics of Social Security claim that the special-issue securities issued by the Treasury are fictitious and contain “worthless IOUs.” As stated earlier, money flowing into the trust funds is invested in U.S. government securities. Because the government borrows from the trust funds and spends the borrowed cash to finance other governmental operations, critics claim that the current increase in trust fund assets and the accumulation of special-issue securities are “worthless IOUs.” Critics claim that the special-issue securities are promissory notes issued by the government to itself, which the government will be unable to honor in the future. Without legislation to restore the long-range solvency of the trust funds, redemption of long-term securities prior to maturity would be necessary. The Social Security Administration rejects the viewpoint that the special-issue securities are “worthless IOUs.” The trust fund investments are far from being worthless. The investments held by the trust funds are backed by the full faith and credit of the federal government. The federal government has always repaid the amounts borrowed from the Social Security trust funds with interest. As such, the specialissue securities are just as safe as U.S. Savings Bonds or other financial instruments guaranteed by the federal government. The Social Security program is currently projected to have a long-range actuarial

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deficit over a 75-year projection period. However, several options are now being considered that will restore long-range trust solvency. These options are discussed later in the chapter.

Financial Condition of Social Security and Medicare The Social Security program and Medicare must be adequately financed to pay all promised benefits. The following section summarizes the financial condition of Social Security and Medicare based on the 2011 annual reports by the Social Security and Medicare Boards of Trustees.5

Trust Fund Cost Estimates Social Security actuaries prepare a short-range (10-year) and a long-range (75-year) cost estimate for the trust funds. Cost estimates are based on current law and those factors that affect the income and outgo of each fund. Assumptions are made concerning economic growth, wage growth, unemployment, inflation, fertility, immigration, mortality, disability incidence and termination, and other factors that affect hospital, medical, and prescription drug costs. Because the future is uncertain, Social Security actuaries prepare three sets of economic, demographic, and program assumptions to reflect the range of future experience. The intermediate assumptions (alternative II) reflect the trustees’ best estimates of future experience. The low-cost estimate (alternative I) is more optimistic and is based on more favorable conditions. The high-cost alternative (alternative III) is more pessimistic and shows the trust fund projections based on less favorable conditions. The projected cost estimates shown in this section are based on the intermediate-cost estimates.

Short-Range Financial Outlook (2011–2020) For the short range, the adequacy of the OASI, DI, and HI trust funds can be measured by comparing their assets at the beginning of the year to projected benefit payments for that year (the trust fund ratio). A trust fund ratio of 100 percent shows that assets are at least equal to projected benefit payments for the year and is a good test of short-term adequacy. This means that even if expenditures exceed income, the trust fund reserves, combined with annual tax revenues, would be sufficient to pay full benefits for several years, which gives Congress time to enact legislation to restore financial adequacy. Based on the short-range test, the OASI Trust Fund is financially adequate throughout the 2011 through 2020 period. However, the DI Trust Fund fails the short-range test because its projected trust fund ratio falls to 90 percent by the beginning of 2013, which is followed by the exhaustion of trust fund assets in 2018. The HI Trust Fund also fails the short-range test of financial adequacy because its projected trust fund ratio declines to 86 percent beginning in 2012. A less stringent annual “contingency reserve” asset test applies to the Supplementary

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Medical Insurance (SMI) Trust Fund for Part B because the major portion of financing comes from Part B premiums and from the general revenues of the federal government, which are automatically adjusted each year to meet expected costs. Moreover, the prescription drug program operates through private insurance plans, which, together with a flexible appropriation for federal costs, eliminates the need for a contingency reserve for the Part D account. However, it should be noted that estimated Part B costs are unrealistically low for 2012 and beyond because the projections assume that the current law, which provides for the reduction of physician fees under the sustainable growth rate system, will not be changed. The estimated reduction in physician fees for 2012 is 29 percent. This reduction is highly unlikely based on the unwillingness of Congress to enforce earlier reductions in physician fees previously scheduled under the law. As such, the understated physician payments will affect the projected costs for Part B, total SMI, and total Medicare. In summary, the OASI trust fund meets the short-range test and is financially adequate, but both the DI and HI trust funds fail the short-range test of financial adequacy. In addition, SMI is projected to put increasing pressure on the federal budget and beneficiaries in the years ahead.

Long-Range Financial Outlook (2011–2085) Social Security actuaries calculate the long-range financial outlook for Social Security and Medicare in a number of ways. These methods include an estimate of the cost of Social Security and Medicare to the economy as measured by the gross domestic product (GDP). Another method is to calculate the long-range actuarial balance for the trust funds. Comparison of Social Security and Medicare with the Economy. The projected costs of scheduled Social Security and Medicare benefits can be compared with GDP, which provides an estimate of the cost to the economy of both programs. The 2011 trustees’ report indicates that costs for both programs will rise substantially through 2035 as large numbers of baby boomers retire. Medicare costs will increase more rapidly than Social Security because of the rising cost of health-care services, increased utilization rates, and anticipated increases in the complexity of health-care services. Social Security program costs were about 4.2 percent of GDP in 2007. These costs are projected to increase gradually to about 6.2 percent of GDP in 2035, then decline to about 6.0 percent by 2050, and remain at about that level through 2085. Under current law, Medicare costs are projected to increase substantially from about 3.6 percent of GDP in 2010 to 5.5 percent of GDP by 2035 and to 6.2 percent of GDP by 2085. However, this figure assumes that mandated reductions in the growth of health-care costs under the new Affordable Care Act (ACA) are fully implemented, and that certain actuarial assumptions are realized. If the ACA assumptions and actuarial assumptions are not realized, then projected Medicare costs could be significantly higher. Long-Range Actuarial Balance. The trust funds can also be viewed in terms of their

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long-range actuarial balances over the entire 75-year valuation period. The actuarial balance is the difference between a trust fund’s annual income and costs, which is expressed as a percentage of taxable payroll, and then summarized over the 75-year projection period. Because the SMI program is balanced annually by premium increases and transfers from general revenues, calculation of an actuarial balance is not a useful concept for that program. The OASI, DI, and HI trust funds each have a long-range actuarial deficit, as a percentage of taxable payroll, as shown below: Long-Range Actuarial Deficit, 2011–2085 (Percentage of Taxable Payroll) OASI    1.92 DI    0.30 OASDI    2.22 HI    0.79 The actuarial deficits can be interpreted as the percentage points that could be added either to the income rate under current law or subtracted from the cost rate for each of the next 75 years to bring the trust funds into actuarial balance. An actuarial balance of zero would be attained if the amount of trust fund assets at the end of the period are equal to the cost for the following year. In the 2011 report to Congress, the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds also highlighted key dates for the trust funds. The dates show the first year the condition is projected to occur and to persist annually through 2085. Key dates include the following: • The projected OASDI actuarial deficit over the 75-year valuation period (2011– 2085) is 2.22 percent of taxable payroll, up from 1.92 percent projected in the 2010 report. The actuarial deficit amounts to 17 percent of tax revenues and 14 percent of program outlays. • The combined OASDI trust fund is projected to be exhausted in 2036. After the OASDI trust fund is exhausted, continuing tax income is projected to be sufficient to pay only 77 percent of the scheduled benefits in 2036 and 74 percent in 2085. • For OASDI, first-year outgo exceeded income, excluding interest, in 2010. As stated earlier, OASDI trust fund assets will be exhausted in 2036. • For OASDI, first-year outgo will exceed income, including interest, in 2023. • The DI trust fund is projected to be exhausted in 2018.The OASI trust fund is projected to be exhausted in 2038. The HI trust fund under Medicare is projected to be exhausted in 2024. • In 2010, the combined OASDI trust fund assets earned an effective annual interest rate of 4.6 percent. • The cost to administer the OASDI program was $6.5 billion in 2010, or about 0.9 percent of total expenditures. As such, administrative costs are relatively low. In contrast, private defined-benefit pension plans have substantially higher administrative costs.

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Solutions to the Long-Range Deficit Eliminating the long-range deficit will require several hard choices. The Social Security program can be actuarially balanced over the next 75 years in various ways. The long-range deficit can be eliminated or reduced by (1) increasing payroll tax revenues, (2) decreasing benefits, (3) using general revenues of the federal government, or (4) some combination of each. The Congressional Budget Office (CBO) recently released a study of policy options to restore long-range solvency to the OASDI program.6 In the study, CBO projects exhaustion of the combined OASDI Trust Fund in 2039, and the 75-year actuarial balance is projected to be –0.6 percent of GDP. (The projected actuarial balance can also be expressed as –1.6 percent of taxable payroll.) This means that, under current law, the financial resources needed to finance the OASDI program over the next 75 years fall short of the benefits that will be owed to beneficiaries by about 0.6 percent of GDP. Stated differently, to bring the OASDI program into actuarial balance over the next 75 years, payroll taxes must be increased immediately by 0.6 percent of GDP and kept at that higher rate, or scheduled benefits must be reduced by an equivalent amount, or some combination of these changes must be implemented. In the study, CBO analyzed 30 policy options that analysts and policymakers have considered to restore long-range financial stability to the OASDI program. The various options assume that initial Social Security benefits will not be reduced for people who are currently older than age 55, and that all options will directly affect the outlays for benefits or federal revenues dedicated to Social Security. The options are classified into five categories: (1) increase the Social Security payroll tax, (2) reduce initial benefits, (3) increase benefits for low earners, (4) raise the full retirement age, and (5) reduce the cost-of-living provisions that apply to continuing benefits. The list of options is not exhaustive and does not include changes that require funding out of the general revenues of the federal government, that create individual retirement accounts for beneficiaries, or that require changes in trust fund investments. The options also do not include changes that would apply only to DI beneficiaries. Finally, changes to federal tax policy are not considered except for an increase in the Social Security payroll tax. Figure 7.1 presents the effects of the policy options on the OASDI trust fund actuarial balance. The CBO defines actuarial balance as the present value of revenues, plus the OASDI trust fund balance at the beginning of 2010, minus the present value of outlays from 2010 to 2084, minus one year’s worth of benefits as a reserve at the end of the period, expressed as a percentage of the present value of GDP over the period. Each option has advantages and disadvantages, and some groups are affected more than others.

Increase the Social Security Payroll Tax Revenues can be substantially increased by raising the payroll tax rate. An acrossthe-board increase in the Social Security payroll tax has the major advantage of significantly reducing the long-range actuarial deficit. For example, assume that the

  159 Figure 7.1  Effects of the Policy Options on the OASDI Trust Fund Actuarial Balance ,QFUHDVHWKHSD\UROOWD[UDWHE\SHUFHQWDJHSRLQWLQ ,QFUHDVHWKHSD\UROOWD[UDWHE\SHUFHQWDJHSRLQWVRYHU\HDUV ,QFUHDVHWKHSD\UROOWD[UDWHE\SHUFHQWDJHSRLQWVRYHU\HDUV (OLPLQDWHWKHWD[DEOHPD[LPXP 5DLVHWKHWD[DEOHPD[LPXPWRFRYHURIHDUQLQJV 7D[FRYHUHGHDUQLQJVDERYHWKHWD[DEOHPD[LPXPGRQRWLQFUHDVHEHQHILWV 7D[FRYHUHGHDUQLQJVXSWRGRQRWLQFUHDVHEHQHILWV 7D[DOOHDUQLQJVDERYHWKHWD[DEOHPD[LPXPDWGRQRWLQFUHDVHEHQHILWV 7D[DOOHDUQLQJVXSWRDWGRQRWLQFUHDVHEHQHILWV 5DLVHIURPWRWKH\HDUVRIHDUQLQJVLQFOXGHGLQWKH$,0( ,QGH[HDUQLQJVLQWKH$,0(IRUPXODWRSULFHV 5HGXFHDOO3,$IDFWRUVE\ 5HGXFHWKHWRSWZR3,$IDFWRUVE\URXJKO\RQHWKLUG 5HGXFHWKHWRS3,$IDFWRUE\RQHWKLUG 5HGXFHDOO3,$IDFWRUVE\DQQXDOO\ ,QGH[LQLWLDOEHQHILWVWRFKDQJHVLQORQJHYLW\ 5HGXFH3,$IDFWRUVWRLQGH[LQLWLDOEHQHILWVWRSULFHVUDWKHUWKDQHDUQLQJV /RZHULQLWLDOEHQHILWVIRUWKHWRSRIHDUQHUV /RZHULQLWLDOEHQHILWVIRUWKHWRSRIHDUQHUV ,QGH[WKHEHQGSRLQWVLQWKH3,$IRUPXODWRSULFHV ,QGH[HDUQLQJVLQWKH$,0(DQGEHQGSRLQWVLQWKH3,$IRUPXODWRSULFHV 5HSODFHWKHFXUUHQW3,$IRUPXODZLWKDQHZWZRSDUWIRUPXOD 0RGLI\WKHVSHFLDOPLQLPXPEHQHILWDQGLQGH[LWWRJURZWKLQHDUQLQJV –0.2 ,QWURGXFHDQHZSRYHUW\UHODWHGPLQLPXPEHQHILW (QKDQFHORZHDUQHUV EHQHILWVRQWKHEDVLVRI\HDUVZRUNHG –0.3 5DLVHWKH)5$WR 5DLVHWKH)5$WR ,QGH[WKH)5$WRFKDQJHVLQORQJHYLW\ 5HGXFH&2/$VE\SHUFHQWDJHSRLQWV %DVH&2/$VRQWKHFKDLQHG&3,8

0.3 0.6

Change the taxation of earnings

0.5 0.6 0.2 0.9 0.5 0.3 0.1 0.1

Change the benefit formula

0.2 0.5 0.7 0.1 0.4 0.2

1.0 0.5 0.4 0.5 0.6 0.2 Increase benefits for low earners

*

0.1 0.3 0.2 0.3 0.2

Raise the full retirement age Reduce cost-of-living adjustments

Notes: The actuarial balance is the present value of revenues plus the OASDI trust fund balance at the beginning of 2010, minus the present value outlays from 2010 to 2084, minus a year’s worth of benefits as a reserve at the end of the period, expressed as a percentage of the present value of GDP over the period. The AIME for a retired worker who reaches age 62 after 1990 is calculated on the highest 35 years of earnings on which that worker paid Social Security taxes (up to the taxable maximum, $106,800 in 2010). Earnings before age 60 are indexed to compensate for inflation and for real (inflation-adjusted) growth in wages; earnings after age 59 enter the computations at nominal values. Dividing total earnings by 420 (35 years times 12 months) yields the AIME. The PIA is the monthly payment to a worker who begins receiving retirement benefits at the full retirement age or to a disabled worker who has never received a retirement benefit reduced for age. For workers who turn 62, become disabled, or die in 2010 (for calculation of survivor benefits), the PIA formula is 90 percent of the first $761 of the AIME, plus 32 percent of the AIME between $761 and $4,586, plus 15 percent of the AIME over $4,586. Those percentages constitute the PIA factors. COLA is an annual increase in benefits indexed to consumer prices. Under current law, the COLA equals the percentage increase in the CPI-W; the chained CPI-U is an alternative measure of inflation. OASDI = Old-Age, Survivors, and Disability Insurance; GDP = gross domestic product; AIME = average indexed monthly earnings; PIA = primary insurance amount; FRA = full retirement age; COLA = cost-ofliving adjustment; CIP-W = consumer price index for all urban wage earners and clerical workers; chained CIP-U = chained CIP for all urban consumers;* = between –0.05 percentage points and zero. Source: Congressional Budget Office.

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payroll tax rate is increased 1 percentage point, or 0.5 percent, for both employees and employers, in 2012. This option improves the 75-year actuarial balance by 0.3 percentage points of GDP and extends the exhaustion date of the OASDI Trust Fund by 17 years to 2056. Although higher payroll tax rates can reduce the long-range deficit, this option has several disadvantages. A higher tax rate would fall heavily on the working poor and low-income groups and would increase the already high level of economic insecurity to which this group is exposed. In addition, an increase in payroll taxes would fall heavily on small business firms and would increase the cost of hiring workers. As a result, small firms, which provide most of the new jobs in the United States, might hire fewer workers because of higher labor costs. Revenues can also be increased by raising the OASDI taxable wage base to a higher amount, or by taxing all covered earnings above the maximum taxable wage base ($106,800 in 2011) without any corresponding increase in benefits. Proponents argue that only upper-income individuals who can afford to pay more would be affected by this change, which is a small price to ensure the program’s solvency. However, opponents argue that support for the OASDI program would gradually be eroded by requiring upper-income workers to pay higher taxes without any corresponding increase in benefits; such workers would see little return for the extra taxes they would have to pay. In addition, a negative means test is introduced by imposing higher taxes on upper-income workers without any increase in benefits, which assumes that upperincome workers do not need the benefits. As such, a basic Social Security principle would be violated regardless of the nature of the means test. Finally, under the Affordable Care Act, the Medicare payroll tax for Hospital Insurance is scheduled to increase for upper-income workers in 2013. An additional increase in the payroll tax on upper-income earners to fund Social Security may produce a backlash and less support for the program.

Reduce Initial Benefits The benefit formula could be changed to reduce costs. Under current law, the highest 35 years of indexed earnings are used to calculate the worker’s average indexed monthly earnings (AIME). One proposal would change the number of years in the calculation of AIME from 35 to 38, which would improve the 75-year actuarial balance by 0.1 percentage points of GDP. However, this option would not significantly extend the exhaustion date of the trust fund. Such a change, however, would tend to hurt workers who enter or leave the labor force several times during their careers, such as working women, who frequently leave or reenter the labor force as family responsibilities change. Another proposal is to reduce all primary insurance amount (PIA) factors by 15 percent. At the time of writing, the factors used in calculating the primary insurance amount are 90 percent (applied to the first $761 of the AIME in 2010), 32 percent (applied to the AIME between $761 and $4,586 in 2010), and 15 percent (applied to AIME over $4,586 in 2010). This option would reduce the PIA factors for newly eligible beneficiaries by 15 percent and would improve the 75-year actuarial balance

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by 0.5 percentage points of GDP and extend the trust fund exhaustion date by 37 years, to 2076. However, this proposal would tend to hurt the working poor with earnings in the 90 percent band because of the reduction in initial benefits. A final approach is to calculate initial benefits based on prices rather than earnings. Under this approach (also called price indexing), the bend points in the benefit formula would be indexed to earnings, as is current law, but the primary insurance amount (PIA) factors would be reduced each year based on the growth in real earnings two years earlier. Starting in 2017, average initial benefits for newly eligible retirees would increase with prices rather than with prices and real earnings. Price indexing would improve the 75-year actuarial balance by 1.0 percentage point of GDP and would result in long-term solvency that can be sustained. However, the use of price indexing in the PIA formula would reduce benefits and hurt low-income workers. A compromise formula would gradually reduce the PIA factors benefits for the top 70 percent of earners (called progressive price indexing), but scheduled benefits for beneficiaries in the bottom 30 percent of lifetime average earnings would not change based on current law.

Increase Benefits for Low-Income Earners In 2008, 3 percent of all married beneficiaries over age 65 were poor. However, 14 percent of the beneficiaries who were not currently married, and 16 percent of the nonmarried beneficiaries in the same age group, were living in poverty.7 The various proposals often include changes that would increase benefits for the poor and lowincome groups. As a result, the 75-year actuarial balance would worsen. For example, one option would enhance the benefits of low-income earners based on the number of years worked. Beginning in 2012, benefits would be increased for workers with low lifetime average earnings and at least 20 years of covered work. This option would increase the cost of Social Security by 0.3 percentage points of GDP, and the trust funds would be exhausted in 2034, five years earlier than CBO expected.

Raise the Full Retirement Age Raising the full retirement age is another method for reducing the long-range deficit. Under present law, the full retirement age ranges from age 65 for those born in 1937 or earlier to age 67 for those born in 1960 or later. The higher full retirement age of 67 will not become fully effective until 2027. Early retirement is still permitted at age 62, but the actuarial reduction in benefits will gradually rise from 20 percent to 30 percent (from 25 percent to 35 percent for spouses) in the future. Proposals include gradually raising the full retirement age to 68 or even to age 70 and beyond. One proposal would gradually raise the full retirement age to 68. CBO estimates the long-range actuarial balance would be improved by 0.1 percentage point of GDP but would not significantly extend the trust fund exhaustion date. If the full retirement age were gradually raised to age 70, the 75-year actuarial balance would be improved by 0.3 percentage points of GDP but also would not significantly extend the trust fund exhaustion date.

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There are persuasive arguments for and against a higher full retirement age. Proponents argue that a higher full retirement age is justified because of the substantial increase in life expectancy over time. Since the Social Security program first began paying benefits at age 65 in 1940, life expectancy has increased by more than 5 years for males and 6 years for females. In addition, a higher full retirement age would reduce the long-range actuarial deficit. However, opponents argue that a higher retirement age will be harmful to minority workers (blacks, Hispanics, and Native Americans), who have lower life expectancies than the general population. Also, a higher full retirement age will hurt workers who have physically demanding jobs or are in poor health; such workers would be forced to work longer for full benefits. Finally, a higher full retirement age is equivalent to a reduction in benefits. For example, CBO estimates that under current law, benefits will be reduced 30 percent for workers with a full retirement age of 67 (someone born in 1960 or later). The reduction in benefits would be 35 percent for the same worker if the full retirement age were raised to 68.8

Reduce the Cost-of-Living Adjustment Another approach is to reduce the cost-of-living adjustment (COLA) that applies each year to measurable changes in the Consumer Price Index. One option is to reduce the COLA by 0.5 percentage points. This proposal would improve the 75-year actuarial balance by 0.3 percentage points of GDP and extend the exhaustion of the trust fund by nine years, to 2048. Proponents of this option maintain that the annual COLA is too high because it is based on a formula that overstates inflation. However, opponents argue that the aged already have high poverty rates, and that a reduction in the COLA will increase economic insecurity for this group. Also, the COLA reductions would be cumulative; as retirees age, their purchasing power falls further behind. Finally, it is argued that the COLA formula has been adjusted, so it is now more accurate in reflecting inflation.

Social Security Game The American Academy of Actuaries has an interactive program on its Web site (www.actuary.org/socialsecurity/game.html) that allows viewers to make hypothetical changes in the Social Security program. The program then shows the estimated change in the long-range actuarial balance based on the Board of Trustees reports. The major advantage of this game is that viewers can recommend certain policy changes to Social Security that are consistent with their political, economic, and ideological beliefs, and immediately see whether the recommended change will significantly reduce the long-range deficit.

Summary • Several financing methods can be used to fund a social insurance program. Payas-you-go financing is a scheme by which scheduled taxes produce the amount of income needed to pay current benefits; a large fund is not built up.

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• Full advance funding is a financing scheme by which taxes or contributions are established to pay the full cost of future benefits as these costs are incurred through current service. This method also provides for the amortization over a fixed period of any past service benefits based on service with the firm prior to establishment of the plan. Under full advance funding, all benefits are paid for or are financed during the years prior to their receipt, and a substantial fund is built up. • Partial advance funding is a financing scheme by which scheduled taxes produce a substantial accumulation of trust fund assets that generate additional interest income and reduce the need for payroll tax increases during periods when costs are relatively high; the trust fund buildup is much smaller than under full advance funding. • The OASI and DI trust funds are currently financed based on partial advance funding. However, at the time of writing and based on current law, the program will operate on a pay-as-you go basis once the trust funds are exhausted (around 2036). • The Social Security program is not fully funded, and full advance funding is not followed. Since the program is expected to continue indefinitely and will not terminate in the predictable future, full funding is considered unnecessary. Also, since the program is compulsory, new entrants will always enter the program and pay taxes to support it. In addition, the taxing and borrowing powers of the federal government can be used to raise additional revenues if the program has financial problems. Finally, from an economic viewpoint, full funding would require substantially higher payroll taxes, which could be deflationary and cause substantial unemployment. • There are four separate trust funds. The Old-Age and Survivors Insurance (OASI) Trust Fund pays retirement and survivors’ benefits; the Disability Insurance (DI) Trust Fund pays disability benefits. Both OASI and DI are often considered on a combined basis (OASDI). For Medicare Part A, the Hospital Insurance (HI) Trust Fund pays for inpatient hospital care and related services. For Medicare Part B, the Supplementary Medical Insurance (SMI) Trust Fund has two separate accounts—Part B, which pays for physician and outpatient services, and Part D, which covers the prescription drug benefit. • The trust funds have several purposes. They provide an accounting method for recording all income to and disbursements from the funds; the trust funds hold the accumulated assets, which provide automatic spending authority to pay benefits; disbursements are limited to benefits and administrative costs. Also, the trust funds provide interest income that helps to reduce the program’s cost. Finally, the trust funds are available as contingency reserves. • The excess of trust fund income over outgo is invested in government securities that are guaranteed as to both principal and interest by the federal government. All securities held by the trust funds are “special issues” of the U.S. Treasury that are available only to the trust funds. Unlike marketable Treasury securities that are available to the general public, special issues can be redeemed at any time at face value. Interest is paid on the special issues held by the trust funds.

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• The trust fund investments are not worthless. The investments held by the trust funds are backed by the full faith and credit of the federal government. The federal government has always repaid the amounts borrowed from the Social Security trust funds with interest. As such, the special-issue securities are just as safe as U.S. Savings Bonds or other financial instruments guaranteed by the federal government. • Social Security actuaries prepare a short-range (10-year) and a long-range (75year) cost estimate for the trust funds. Because the future is uncertain, three sets of economic, demographic, and program assumptions are prepared to reflect the range of future experience. The intermediate assumptions (alternative II) reflect the trustees’ best estimates of future experience. • For the short range, the adequacy of the OASI, DI, and HI trust funds can be measured by comparing their assets at the beginning of the year to projected benefit payments for that year (the trust fund ratio). A trust fund ratio of 100 percent shows that assets are at least equal to projected benefit payments for the year and is a good test of short-term adequacy. The OASI program meets the short-range test and is financially adequate, but both the DI and HI trust funds fail the short-range test of financial adequacy. • The actuarial balance of a fund is the difference between annual income and costs, which is expressed as a percentage of taxable payroll, and then summarized over a 75-year projection period. The OASI, DI, and HI trust funds each have a 75year actuarial deficit as a percentage of taxable payroll. The projected OASDI actuarial deficit over the 75-year long-range period (2011-2085) is 2.22 percent of taxable payroll. • The projected point at which the combined OASDI trust fund will be exhausted occurs in 2036. After the trust fund is exhausted, continuing tax income is projected to be sufficient to pay 77 percent of scheduled annual benefits in 2036 and 74 percent in 2085. • The Social Security program can be actuarially balanced over the next 75 years in various ways. The long-range deficit can be eliminated or reduced by (1) increasing payroll taxes, (2) decreasing benefits, (3) using general revenues of the federal government, or (4) some combination of each.

Review Questions 1. Describe the financing methods that could be used to finance Social Security. What method is currently followed in the financing of Social Security? 2. Explain why it is unnecessary to have a fully funded OASDI program. 3. Identify the trust funds in the Social Security and Medicare programs. 4. Briefly explain the basic purposes of the Social Security and Medicare trust funds. 5. Explain how the Social Security and Medicare trust funds are invested. 6. Describe the short-range financial condition of Social Security and Medicare. Identify the trust funds that do not meet the short-range test. 7. Describe the long-range financial condition of Social Security and Medicare. Identify the trust funds that do not meet the long-range test.

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8. Some critics claim that the Social Security trust funds are fictitious and contain worthless assets. Evaluate this allegation. 9. List the possible options for reducing or eliminating the long-range actuarial deficit. 10. Briefly explain the advantages and disadvantages of each option listed in (9), above. .

Application Questions 1. There is no single solution to reducing or eliminating the long-range actuarial deficit in the Social Security program. The Academy of Actuaries has a game that allows viewers to make hypothetical changes to the Social Security program to eliminate the long-range deficit. Go to www.actuary.org/socialsecurity/game.html and answer the following questions: a. Based on your ideological and political beliefs, what options would you recommend for reducing or eliminating the long-range deficit? Explain your answer. b. Briefly explain the advantages and disadvantages of each option selected in (a), above. c. Do you have any additional recommendations for reducing or eliminating the long-range deficit? Explain your answer. 2. The Social Security trust funds are invested in government securities that are both similar and dissimilar to other government securities available to the public. a. Explain how the excess of income over outgo is invested in the Social Security trust funds. b. Explain how the Social Security trust fund investments are similar to other government securities available to the public. c. Explain how the Social Security trust fund investments differ from other government securities available to the public.

Internet Resources • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on Social Security and Medicare on its Web site. Visit the site at www.nasi.org • The National Commission to Preserve Social Security has the goal to protect, preserve, promote, and ensure the financial security, health, and well-being of current and future generations of older Americans. The organization issues timely articles and studies on the current Social Security and Medicare programs. Visit the site at www.ncpssm.org • Social Security Online is the official Web site for the Social Security Administration, which administers the Social Security (OASDI) program in the United States. The site provides updated information on retirement, survivor, and disability benefits and recent changes in the program. Visit the site at www.socialsecurity.gov or www.ssa.gov

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• The Office of the Chief Actuary in the Social Security Administration provides actuarial cost estimates of the OASDI program and determines the annual costof-living adjustments in OASDI benefits. The site provides a number of timely publications. Visit the site at www.socialsecurity.gov/OACT • The Social Security Advisory Board advises the president and Congress on issues relating to the Social Security program in the United States. The site provides timely and relevant reports dealing with Social Security. Visit the site at www.ssab.gov

Selected References American Academy of Actuaries. Social Security Reform Options. Public Policy Monograph, Washington, DC, January 2007. The Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office, 2011. The Boards of Trustees, Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds. 2011 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds. Washington, DC: U.S. Government Printing Office, 2011. Congressional Budget Office. Social Security Policy Options. Publication no. 4140, Washington, DC, July 2010. Social Security and Medicare Boards of Trustees. Status of the Social Security and Medicare Programs: A Summary of the 2011 Annual Reports. Washington, DC, 2011. Social Security Online. Office of the Chief Actuary. “Trust Fund Data, Trust Fund FAQs.” Available at www.­socialsecurity.gov/OACT/ProgData/fundFAQ.html. Special Committee on Aging, United States Senate. Social Security Modernization: Options to Address Solvency and Benefit Adequacy. Washington, DC: U.S. Government Printing Office, 2010.

Notes 1. The Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, “Glossary.” The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2011), p. 212. 2. Ibid, p. 216. 3. Personal correspondence with Alice Wade, Deputy Chief Actuary, Long Range, August 13, 2010. 4. This section is based on Social Security Online, Office of the Chief Actuary, “Trust Fund Data, Trust Fund FAQs.” Available at www.socialsecurity.gov/OACT/ProgData/fundFAQ.html 5. This section is based on Social Security and Medicare Boards of Trustees, Status of the Social Security and Medicare Programs: A Summary of the 2011 Annual Reports (Washington, DC, 2011); The Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2011); and The Boards of Trustees, Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, 2011 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds (Washington, DC: U.S. Government Printing Office, 2011). 6. Congressional Budget Office, Social Security Policy Options. Publication no. 4140, Washington, DC, July 2010. 7. Ibid. 8. Ibid.

8 Problem of Poor Health and Health-Care Reform

Student Learning Objectives After studying this chapter, you should be able to: • Explain the major health-care problems in the United States. • Identify the major factors that can explain the historical increase in health-care expenditures in the United States. • Explain the reasons why some people are uninsured and the consequences of being uninsured. • Explain the defects in private health insurance that led to passage of the Patient Protection and Affordable Care Act. • Describe the major characteristics of the Patient Protection and Affordable Care Act. • Describe the health insurance reforms under the Patient Protection and Affordable Care Act. • Explain the characteristics of the Pre-Existing Condition Insurance Plan. • List several provisions in the Patient Protection and Affordable Care Act that may improve the quality of care and lower costs. Millions of people in the United States become sick or disabled each year. People with serious health issues have two major problems—payment of catastrophically high medical bills and replacing the loss of earned income. Medical care is expensive. Major surgery or an extended illness or injury can easily cost $50,000, $100,000, $200,000, or some higher amount. Millions of people, however, have no health insurance to pay these bills. As a result, the uninsured are exposed to serious economic insecurity. In addition, many sick or disabled people experience severe economic insecurity even if they have health insurance. Because of inadequate benefits, numerous exclusions, and limited policies, many Americans with health insurance cannot pay their medical bills and must declare bankruptcy each year. A national study of bankruptcies by Harvard researchers concluded that medical problems contributed to 62 percent of all bankruptcies in 2007. Three-quarters of the filers had health insurance.1 167

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Finally, a severe illness or an extended long-term disability can expose uninsured workers to great economic insecurity. There is the loss of earned income, medical expenses that continue, savings may be depleted, employee benefits may be lost or reduced, and someone must care for the permanently disabled person. Health-care experts generally agree that the present health-care delivery system has serious problems and must be reformed. In this chapter, we discuss the economic problem of poor health and health-care reform in some detail. The chapter is divided into two major parts. The first part discusses the major health-care problems in the United States that resulted in legislation to reform health care. The second part discusses the new Patient Protection and Affordable Care Act that was enacted in 2010 to reform the present health-care delivery system. The new law extends health-care coverage to 32 million uninsured Americans, provides substantial subsidies to uninsured individuals and small business firms to make health insurance more affordable, contains provisions to lower health-care costs in the long run, and prohibits insurers from engaging in certain practices. The legislation also prohibits medical underwriting based on health status, exclusions for pre-existing conditions, maximum limits on lifetime benefits and unreasonable annual limits on benefits, and rescission of health insurance policies when insured people get sick. Although most provisions do not become effective until 2014, some provisions are now in force.

Health-Care Problems in the United States The United States provides the highest-quality health care in the world. Yet despite major advances in medicine, health-care experts maintain that the present healthcare delivery system is broken and must be reformed. The system has the following problems, which led to the enactment of the Patient Protection and Affordable Care Act in March 2010. • Rising health-care expenditures • Large number of uninsured in the population • Uneven quality of medical care • Considerable waste and inefficiency • Defects in financing health care • Abusive insurer practices

Rising Health-Care Expenditures Total health-care expenditures in the United States have increased substantially over time and are growing faster than the national economy. According to the Centers for Medicare & Medicaid Services, estimated national health expenditures totaled $2.7 trillion in 2011, or 17.3 percent of the nation’s gross domestic product. Thus, more than one in six dollars of the nation’s income is now spent on health care. If present trends continue, estimated national health expenditures will total $4.5 trillion in 2019, or 19.3 percent of our gross domestic product.2

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Comparison with Other Nations The United States leads the world in total spending on health care. U.S. health-care expenditures as a percentage of the nation’s gross domestic product, and compared to like figures for other selected countries, are as follows:3 United States 16.2% (2008) Germany, France, Switzerland 10.1% to 13.0% Canada, United Kingdom, Australia, Norway, Sweden   8.1% to 10.0% Japan, Finland   5.1% to 8.0% China, India   3.1% to 5.0% Despite the higher spending levels, life expectancy in the United States ranks poorly when compared with other major foreign countries. Among members of the United Nations, the United States ranked 34th in the world in estimated overall life expectancy at birth for 2011, behind Japan, Canada, Spain, Germany, the United Kingdom, and most of Europe.4 There are several reasons for the poor showing, including the following: • A large percentage of adult Americans are obese, which leads to coronary heartdisease, cancer, diabetes, and other health problems. • Many Americans lead sedentary lives, fail to exercise, and have diets high in saturated fats. • Millions of Americans lack health insurance and may not receive needed medical care. • Blacks and other minority groups have shorter life expectancies, which pulls down the average. • Infant mortality rates are relatively high when compared with many other industrialized nations.

Reasons for the Increase in Health-Care Expenditures Health-care economists have identified numerous factors that explain in large part the substantial increase in health-care expenditures over time. These factors include the following: 5 • Increase in consumer demand. Consumer demand for health-care services has increased over time because of an increase in the population, rising per capita incomes, and greater health awareness among Americans. The Congressional Budget Office (CBO) estimates that growth in average per capita income accounts for 5 percent to approximately 20 percent of the growth in long-term spending on health care.6 • Advances in technology. Development of new technology and advances in existing technology are major drivers of health-care costs. Examples include diagnostic imaging, coronary bypass procedures, bone marrow transplants, neonatal intensive

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care, and renal replacement therapy for kidney failure. The CBO estimates that about half of all growth in health-care spending in the past several decades was associated with changes in medical care made possible by advances in technology. • Cost insulation because of third-party payers. Health-care experts claim that consumers are insulated from the true cost of health care because they are not paying directly for the care they receive. Most health-care costs are paid by third-party payers, such as employers, private insurers, and government, which typically pay a large part of the total cost. As a result, patients generally have little or no incentive to control costs, which encourages them to consume more health-care services than they ordinarily would. As a source of spending, government payments from Medicare, Medicaid, and other public sources, as well as payments from private health insurance, accounted for 80 percent of the nation’s health-care dollars at the end of 2006.7 As a result, out-of-pocket payments by patients have declined relatively over time because of the substantial increase in payments by third parties, which reduce incentives of patients to control cost. • Employment-based health insurance. Most people today obtain their health insurance coverage through an employer-employee group. Health-care experts believe that many of the health-care problems in the United States can be traced directly to employment-sponsored health insurance. This is true for several reasons. First, qualified group health insurance plans receive favorable tax treatment. Employers receive an income-tax deduction for their contributions, and the contributions are not taxable income to employees. Critics argue that, as a result of earlier collective bargaining and the heavy tax subsidy, employers and employees historically have often selected the more costly and comprehensive types of health insurance plans, which have driven up costs. Second, as stated earlier, critics argue that third-party payments for health insurance by employers insulate the employees from the true cost of health care, which reduces the financial incentives of employees to control costs. Finally, group health insurance is temporary and not portable. Employees generally lose their group health coverage if they are laid off, fired, or retire. To deal with these problems, critics propose that individual health insurance should receive greater emphasis so that employees would still have coverage after they leave the group and also have a greater incentive to control costs. • State-mandated benefits. The states require health insurers to cover specific diseases or groups, such as newly born infants, alcoholics and drug addicts, the mentally ill, persons receiving care from chiropractors and psychologists, and physically and mentally handicapped persons. The mandated benefits increase the utilization of medical services and drive up costs. • Increased spending on prescription drugs. Spending on prescription drugs was not always a major factor in total health-care spending. However, since the mid-1990s, spending on prescription drugs has increased in importance as a driver of health-care costs. Prescription drugs accounted for 10 percent of total spending on health care at the end of 2006.8 • Cost shifting by health-care providers. Medicare and Medicaid programs do not pay the full cost of providing care to patients. As a result, health-care providers may

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shift unreimbursed Medicare and Medicaid costs to private payers, such as auto insurers in the case of driving-related injuries, which increases claim costs and ultimately results in higher premiums for policyholders. For example, a study by the Insurance Research Council (IRC) of auto insurance bodily injury liability claims in 38 states concluded that low reimbursement rates in public health insurance programs such as Medicare and Medicaid prompted hospitals to shift unreimbursed costs to auto insurers, which increased auto injury claim costs and forced auto insurers to scrutinize claims more closely and negotiate hospital bills prior to payment. The IRC estimates that, for bodily injury (BI) liability claims in 38 states, cost shifting in 2007 resulted in $1.2 billion in excess hospital charges.9 • Higher administrative costs. The costs of administering public and private health insurance programs have also increased over time. From 1995 to 2005, spending on administrative services increased by about 7 percent each year.10 The fastest-growing components of administrative costs were customer service, information technology, and medical management. • Rising prices in the health-care sector. The prices of medical goods and services have increased more rapidly over time than the overall price level. Some analysts believe that rising prices in the health-care sector is another contributing factor in total health-care spending. However, a CBO study concludes that rising prices in the health-care sector account for no more than one-fifth of the long-term real increase in total health-care spending.11 • Defensive medicine. The fear of being sued for medical malpractice has forced physicians to practice defensive medicine. Defensive medicine refers to the ordering of unnecessary diagnostic tests, or tests with little clinical value to patients, and longer-than-necessary hospital stays. Health-care costs are increased as a result. • Other factors. Other factors that drive up health-care costs include the cost of emergency room treatment and inpatient hospital care for uninsured patients, and health-care fraud and abuse by some providers and patients. • Finally, contrary to popular belief, aging of the population is not a major contributing factor to the overall growth in health-care spending. According to the CBO, the percentage of aged people in the population has increased during the past four decades, but the increase was too gradual and insubstantial to account for a large percentage of the increase in per capita spending on health care. The CBO estimates that changes in the age distribution in the population from 1965 to 2005 accounted for only about 3 percent of the cumulative increase in total spending that occurred during that period.12 As a result of the substantial increase in medical costs, many sick people delay seeing a doctor or other health-care professional. A Kaiser Family Foundation study found that 6 in 10 respondents reported putting off medical care due to cost. The most common actions taken were the substitution of home remedies and over-the-counter drugs for doctor visits (42 percent) and skipping dental care or checkups (36 percent). In addition, 3 in 10 (29 percent) did not fill a prescription for medicine, and 2 in 10 (18 percent) cut pills in half or skipped care.13

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Large Number of Uninsured in the Population Another serious problem is the large number of uninsured persons in the population. According to the 2011 Current Population Survey, 49.9 million people, or 16.3 percent of the population, had no health insurance coverage in 2010.14 Groups with relatively large numbers of uninsured persons include the following:                            

Foreign born 34.1% Hispanic (any race) 30.7% Young adults (ages 18 to 24) 27.2% Household income under $25,000 26.9% Black 20.8% Asian 18.1% Household income $75,000 or more   8.0%

In addition, many states have high proportions of uninsured. These states include Texas (25.0 percent), Florida (21.3 percent), New Mexico (21.3 percent), California (19.4 percent), Georgia (19.9 percent), and Arizona (19.0 percent). Finally, a high percentage of the self-employed and small business firms are uninsured primarily because of prohibitively high premiums. In 2008, 61 percent of the self-employed and small business firms with fewer than 25 employees had no health insurance coverage.15 Unlike major corporations, which have strong bargaining power, small business firms typically have little or no bargaining power and are unable to negotiate favorable rates and discounts with large insurers. Moreover, if an employee in a small company incurs sizable medical expenses because of a serious illness, the small business owner is often faced with a significant premium increase, which may make coverage unaffordable. For example, the co-owner of a small firm with seven employees in Lincoln, Nebraska, had a wife with breast cancer. Her medical bills exceeded $90,000. As a result, even with a $4,000 deductible, the company faced a 42 percent increase in premiums in 2010. To hold down the premium increase to 30 percent, the firm had to increase the deductible to $6,000.

Length of Time People Are Uninsured The problem of the uninsured is even more severe when the length of time that people are uninsured is considered. In a recent report, the Centers for Disease Control and Prevention (CDC) released selected estimates of health insurance coverage for the noninstitutionalized population based on the 2010 National Health Insurance Survey. The CDC report revealed the following:16 • From January through June 2010, 49.1 persons of all ages (16.2 percent) were uninsured at the time of the interview. • Some 60.8 million persons (20 percent) had been uninsured for at least part of the year prior to the interview. • Some 35.6 million (11.7 percent) had been uninsured for more than a year at the time of the interview.

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When the data are broken down by age groups, for adults under age 65, the problem of being uninsured for extended periods is especially severe, especially for unemployed adults. The CDC report revealed the following: • From January through June 2010, 60 percent of unemployed adults ages 18 to 64 had been uninsured for at least part of the past year. • Also, 36.9 percent of unemployed adults ages 18 to 64 had been uninsured for more than a year. People uninsured for extended periods are exposed to great economic insecurity. According to Families USA, the consequences of being uninsured are severe. They include the following:17 • The uninsured often delay or skip needed medical care because of high costs. Uninsured adults are six times as likely as privately insured adults to go without needed medical care because of cost. • When the uninsured receive medical care, they frequently pay more for that care. The uninsured cannot negotiate discounts on hospital and physician charges that insurers obtain in their contract negotiations with health-care providers. As a result, the uninsured typically pay more for their care. • With the exception of an emergency room, uninsured adults are less likely to have a regular source of medical care. • The uninsured often do not have access to regular screenings and preventive care. As a result, uninsured adults are substantially more likely to be diagnosed with a disease in an advanced stage, such as advanced stage breast cancer. • The uninsured are sicker and die earlier than people with insurance. Adults without health insurance are 25 percent more likely to die prematurely than adults with private health insurance.

Reasons Why People Are Uninsured Another study by the National Public Radio, the Kaiser Foundation and Harvard School of Public Health identified several reasons why adults have no health insurance.18 The major reason cited is cost: health insurance is too expensive to purchase (37 percent). Other reasons include lack of employment or job loss (22 percent); not being eligible for coverage under an employer’s plan or lack of an employer plan (11 percent); and not needing it (9 percent). Also, some people are uninsured because they have been refused coverage by insurers due to poor health, illness, or age (4 percent). Finally, still other reasons explain why some people are uninsured. Some lowincome people are eligible for coverage under the Medicaid program but fail to sign up because they are unaware they are eligible. Others with relatively high incomes do not purchase health insurance because they view spending on health insurance as a low priority. Finally, many younger people believe they are healthy, and that health insurance is unnecessary.

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Uneven Quality of Medical Care The quality of medical care in the United States varies widely depending on the physician, geographic location, and type of disease being treated. Each year, the National Committee for Quality Assurance (NCQA) examines the quality of commercial healthcare plans based on data submitted by health insurance plans across the country. The evaluation of care is based on measures that assess how often patients receive care that conforms to evidence-based guidelines. The assessment ranges from prevention to chronic disease management, which include immunizations, cancer screenings, blood pressure control, advice to quit smoking, and medication management. NCQA concludes that, although the quality of care has improved, there is significant variation in quality across different regions of the country. As a result, many patients receive substandard care. The quality of care varies widely depending on geographic location. Commercial health plans in Maine, New Hampshire, Vermont, Massachusetts, Connecticut, and Rhode Island received quality scores that were substantially above the national average. In contrast, plans in Texas, Oklahoma, Arkansas, Louisiana, Mississippi, Alabama, Tennessee, and Kentucky had quality scores that were substantially below the national average. NCQA concludes that eliminating variations in the delivery of evidence-based care could save up to 88,000 lives each year.19 To put things in perspective, this number is more than double the number of people who die each year in motor vehicle accidents.

Waste and Inefficiency Another problem is considerable waste and inefficiency in the present system. Recent estimates indicate that the system wastes up to $800 billion each year, or almost onethird of total health-care spending. Wasteful spending includes the following: • Duplication of tests because health-care records from other providers are not readily available • Medical errors by hospitals and physicians that are largely preventable • Unnecessary tests and treatment by physicians due to fear of malpractice ­lawsuits • High administrative costs and excessive and redundant paperwork by health-care providers • Readmissions into hospitals because initial treatment was inadequate or ­ineffective • Hospitalizations for preventable conditions, such as uncontrolled diabetes, which are less costly when treated promptly • Overuse and duplication of expensive medical technology by health-care providers, such as magnetic resonance imaging (MRI) tests Another costly and wasteful practice is the overuse of hospital emergency rooms. For many uninsured Americans, the only available source of medical care is treatment

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in a hospital emergency room. As a result, emergency rooms in public hospitals provide a substantial amount of care for nonemergency treatment, which is very expensive and places severe stress on both medical personnel and physical facilities. An office visit might cost $100, but treatment in an emergency room could cost $800 or more. In addition, medical care from emergency rooms does not provide for routine examinations or preventive care, and some uninsured persons with chronic health conditions use emergency rooms repeatedly. Finally, even when medical care is available from a clinic in a public hospital, it can take weeks to get an appointment, and patients often must wait for hours before they are examined by a physician.

Defects in Financing Health Care Critics argue that the financing of health care in the United States is defective and aggravates many of the problems discussed earlier. They point out the following defects: • Based on ability to pay. The present system is based largely on the person’s ability to pay and not on the basis of health needs. Thus, it is argued, many uninsured Americans with serious health problems do not receive needed care because they cannot pay for it. • Fee-for-service defects. The traditional fee-for-service method of compensating physicians often works in a perverse way. Under this system, the more services and tests that physicians provide, the higher are their incomes. Physicians are generally compensated based on the number of medical services provided and not on the medical outcomes of their patients. The fee-for-service method may encourage some physicians to prescribe unnecessary medical tests and ­treatment. • Distortions in medical care. It is argued that the present system results in a distortion in medical care. For example, because specialists earn higher incomes, medical school graduates typically enter specialty fields and abandon general practice, which limits the supply of general practice physicians. Also, because of potentially higher incomes, some physicians prefer to practice medicine in the cities and suburbs rather than in rural areas, which exacerbates the shortage of rural physicians.

Abusive Insurer Practices Although more than 1,000 insurers sell health insurance, the business is highly concentrated at the state and local level. A small number of health insurers, typically one to three insurers, dominate the local markets and account for a relatively large share of total health insurance premiums. In 26 states, a single insurer controls 50 percent or more of the market. In 40 states, two insurers control 50 percent or more of the market.20 In 2009, an American Medical Association survey of insurance markets in 313 metropolitan areas showed that in 92 percent of the markets, one or more insurers had a market share of 30 percent or more.21 As a result of market dominance, critics argue that health insurers can engage in questionable business practices and abuses that increase their profits but are harmful to insurance consumers.

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Abusive practices, which provided strong support for enactment of the new Patient Protection and Affordable Care Act, included exclusions for pre-existing conditions, rescissions of insurance policies, lifetime dollar limits and annual limits on benefits, and sizable variations in premiums because of underwriting factors.

Exclusions for Pre-existing Conditions Individual health insurance policies typically contain exclusions for pre-existing conditions. A pre-existing condition is a physical or mental condition that existed during some specified time period prior to the effective date of the policy for which the insured received medical treatment. Pre-existing conditions are not covered until the policy has been in force for a specified period, such as two years, unless the condition is disclosed in the application and is not excluded by a rider. If the condition is disclosed in the application, the applicant may be charged a higher rate, or the condition may be excluded by a rider to the policy. However, the House and Senate debates and congressional hearings revealed that many insurers were denying legitimate claims because of a pre-existing condition not disclosed in the application. Examples of denied claims include the following: (1) an insured woman had a C-section in the delivery of her baby, which was considered a pre-existing condition; (2) another insured woman with aggressive breast cancer had her claim denied because she did not disclose earlier treatment for acne; and (3) an insured person who experienced domestic violence was considered as having a pre-existing condition. The Committee on Energy and Commerce in the House of Representatives investigated the extent of coverage denials and exclusions for pre-existing conditions in the individual market. Key findings in the investigation are as follows:22 • From 2007 through 2009, the four largest for-profit health insurers, Aetna, Humana, UnitedHealth Group, and WellPoint, refused to issue health insurance coverage to more than 651,000 people based on their prior medical history. On average, the four companies denied coverage to one out of every seven applicants based on a pre-existing condition. One company maintained a list of over 400 medical diagnoses that triggered a permanent denial of health insurance coverage to applicants. • From 2007 through 2009, the number of people denied coverage for pre-existing conditions increased at a rapid rate. The number of individuals denied coverage by Aetna, Humana, UnitedHealth Group, and WellPoint increased from 172,400 in 2007 to 257,100 in 2009, an increase of 49 percent. During the same period, applications for enrollment increased by only 16 percent. • From 2007 through 2009, Aetna, Humana, UnitedHealth Group, and WellPoint refused to pay 212,800 claims for medical treatment due to pre-existing conditions. In some cases, the companies offered health insurance to individuals with pre-existing conditions, but used medical riders to exclude coverage or to increase the deductible for pre-existing conditions. In the case of one company, nearly 15 percent of the insureds in the individual market in 2010 had policies with riders that limited coverage or required higher deductibles for certain medical ­conditions.

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• Each company had business plans that relied on using pre-existing conditions to limit the amount of money paid for medical claims. In one document, executives devised a plan for strategic growth in the individual market that identified areas of opportunity, which included improved pre-existing conditions exclusion processes, tighter condition and claim review, and tighter underwriting guidelines. Other internal corporate documents show that insurance company executives were considering practices such as assessing separate deductibles specifically for identified pre-existing conditions; denying payments for prescription drugs related to pre-existing conditions; linking additional claims to pre-existing conditions exclusions; and narrowing the definition of prior creditable insurance coverage. • Pregnant women, expectant fathers, and families attempting to adopt children generally were unable to obtain health insurance in the individual market. The four largest for-profit health insurers, Aetna, Humana, UnitedHealth Group, and WellPoint, have each listed pregnancy as a medical condition that would result in an automatic denial of individual health insurance coverage. Also, health insurers sometimes exclude from coverage expectant fathers, candidates for surrogacy whether they are the surrogate or recipient, and those in the process of adoption. The new Affordable Care Act prohibits the use of pre-existing conditions to deny coverage for claims. For children, this provision is effective for policies issued on or after September 23, 2010. For others, the ban on pre-existing conditions becomes effective in 2014. As a result, health insurers will no longer be able to deny coverage to applicants because of their medical history. Also, beginning in 2014, health insurers will no longer be able to deny coverage to women because they are pregnant or exclude maternity-related claims.

Rescission of Insurance Contracts to Limit Benefits The House and Senate hearings prior to enactment of the new law revealed that some insurers rescinded individual health insurance policies to avoid paying large claims, such as those submitted by insured individuals with advanced cancer or large medical bills. Rescission means insurers can cancel an individual policy because of misrepresentation, fraud, or concealment of a pre-existing condition by the insured when the policy is first issued. The time limit for contesting a claim in an individual policy generally is two years. However, congressional hearings revealed that some insurers would collect premiums, and if the insured later submitted an expensive claim, his or her medical records would be examined to determine if the insured failed to disclose some medical condition when the policy was first issued. If any omissions or discrepancies were discovered, the insurer would refuse to pay for any additional treatment and would try to cancel the coverage retroactively. The result was that some patients with serious health problems, such as advanced breast cancer or heart disease, had their policies rescinded at the time when they were undergoing necessary and expensive treatment. A House investigation revealed large insurers

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rescinded some 20,000 policies over a five-year period. Likewise, a survey by the National Association of Insurance Commissioners revealed more than 27,000 rescissions over an overlapping five-year period.23 Although rescissions are only a small fraction of total individual policies in force, the result is a financial catastrophe for the seriously ill patients whose policies are canceled. The new law now prohibits insurers from rescinding insurance contracts when claims are filed, except in cases of fraud or intentional misrepresentation of a material fact. This provision became effective six months after enactment of the health-care reform law and is now in effect.

Lifetime Limits or Annual Limits on Benefits Prior to enactment of the health-care reform law, individual and group coverage typically contained lifetime and annual limits on benefits. As a result, insured people with serious health conditions requiring treatment over an extended period often exhausted their benefits. Many policies had relatively low lifetime and annual limits. As a result, some insured patients could not pay their medical bills and were forced into bankruptcy even though they had some type of insurance policy. As stated earlier, a national study of bankruptcies by Harvard researchers concluded that medical problems contributed to 62 percent of all bankruptcies in 2007. Three-quarters of those filing for bankruptcy had health insurance. Most filers were well educated, owned homes, and had middle-class occupations.24 The 2010 health-care reform law now prohibits insurers from imposing lifetime limits on benefits. Also, prior to 2014, annual limits can only be imposed on individual and group plans as determined by the Secretary of Health and Human Services. The new law restricts and phases out any annual dollar limits on covered benefits that may be present in group plans and in individual health insurance plans for a plan year or policy year starting on or after September 23, 2010. These plans cannot have annual dollar limits that are lower than the following: • $750,000 for a “plan year” or “policy year” starting on or after September 23, 2010, but before September 23, 2011. • $1.25 million for a plan year or policy year starting on or after September 23, 2011, but before September 23, 2012. • $2 million for a plan year or policy year starting on or after September 23, 2013, but before January 1, 2014. As stated earlier, beginning in 2014, annual dollar limits on most covered benefits are not allowed.

Sizable Variations in Premiums Because of Underwriting Factors Another abuse was the sizable variation in premiums in the individual market because of underwriting factors. In addition to the applicant’s health, insurers earlier considered other variables in the underwriting of individual policies, which typically included age, gender, occupation, geographic location, hobbies, height, weight, and even the applicant’s credit history. The majority of states did not place any restrictions on the additional premiums that could be charged for these factors. Congressional debate

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revealed that females were often charged as much as 40 percent more for the same age and coverage charged to males. Likewise, one study revealed that, when only age and health status are considered, one person may be charged nine times more for the same coverage provided another person.25 The 2010 health-care reform law places severe restrictions on the number of underwriting factors that insurers can use. Beginning in 2014, premiums can vary based only on age (limited to no more than a 3:1 ratio), premium rating area, family size, and tobacco use in the individual and small group markets and in the Health Insurance Exchanges. As discussed later, Health Insurance Exchanges will be created in the states to provide a new transparent and competitive insurance marketplace where individuals and small firms can buy affordable health insurance.

Earlier Health-Care Reform Efforts Health-care reform in the United States became necessary because of the defects in the health-care delivery system. The need for reform is not new. In 1912, Theodore Roosevelt included national health insurance in his presidential campaign. In 1935, President Franklin D. Roosevelt signed into law the Social Security Act, which included grants for child and maternal health care. In 1943, the Wagner-Murray-Dingell bill in the Senate would have created a national compulsory health insurance program for most employees and their descendants, but Congress did not act on the legislation. After Roosevelt’s death in 1945, President Harry Truman continued to push for health-care legislation. However, the American Medical Association, opposition from conservative members of Congress, and the outbreak of the Korean War blocked his efforts. In 1974, President Richard Nixon pushed for comprehensive health insurance legislation but was unsuccessful. In 1993, President Bill Clinton introduced a comprehensive health-care reform plan, but the plan was blocked by conservative members of Congress, the insurance industry, and lobbyists for special-interest groups. In 2009, President Barack Obama strongly supported legislation that would overhaul and reform the health-care delivery system. On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act of 2010 (Affordable Care Act). Conservative members of Congress strongly opposed the legislation, primarily because of ideological and political beliefs. They feared that the legislation would result in a government takeover of health insurance and that the federal deficit would be substantially increased; they also believed that people should not be required to purchase insurance against their will. However, despite bitter and contentious congressional debate, and numerous parliamentary procedures to block the legislation, the legislation passed and was enacted into law on March 23, 2010. Not a single Republican in the Senate voted for the legislation.

Basic Provisions of the Affordable Care Act As stated earlier, the Affordable Care Act extends health-care coverage to 32 million uninsured Americans, provides substantial subsidies to uninsured individuals and

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small business firms to make health insurance more affordable, contains provisions to lower health-care costs in the long run, and prohibits insurers from engaging in certain abusive practices. In this section, we discuss the basic provisions of the law.26 Because the legislation is complex and comprehensive, it is beyond the scope of the text to discuss all provisions in detail. Instead, we focus primarily on provisions that affect individuals, families, employers, insurers, and health-care providers. These provisions include the following: • Individual Mandate • Employer Requirements • Health Insurance Exchanges • Benefit Categories • Premium and Cost-Sharing Subsidies to Individuals • Premium Subsidies to Small Employers • Early Retirement Reinsurance Program • Expansion of Medicaid • Health Insurance Reforms • Pre-Existing Condition Insurance Plan • Long-Term Care (CLASS Act) • Improving Quality and Lowering Costs • Cost and Financing

Individual Mandate Beginning in 2014, most citizens and legal residents in the United States will be required to have qualifying health insurance or pay a tax penalty. In 2014, the penalty will be $95 (or l percent of income if higher) and will gradually increase to $695 (or up to 2.5 percent of income) in 2016. Certain groups are exempt from mandatory coverage. Exemptions are granted for financial hardship, religious objections, Native Americans, individuals who go without coverage for less than three months, incarcerated individuals, and undocumented immigrants. Also exempt are individuals for whom premiums for the lowest-cost plan exceed 8 percent of their income, and people with incomes below the annual thresholds for filing federal income tax returns.

Employer Requirements The Affordable Care Act does not require employers to offer health insurance to their employees. Larger employers, however, are assessed a penalty if they do not provide health insurance to covered employees. The law specifically exempts employers with fewer than 50 full-time employees. However, employers with 50 or more fulltime employees that do not offer coverage to their employees, and for whom at least one full-time employee receives a premium tax credit through a Health Insurance Exchange (explained below), will be assessed an annual fee of $2,000 for each fulltime employee (excluding the first 30 employees from the assessment). However, employers with 50 or more full-time employees that do provide coverage to their

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employees, and have at least one full-time employee who is receiving a premium tax credit, will be assessed $3,000 for each employee receiving the premium credit or $2,000 for each full-time employee, whichever is lower (again excluding the first 30 employees from the assessment). Employers that offer health insurance to their employees will be required to provide a voucher to employees with incomes below 400 percent of the federal poverty level, and whose share of the premiums is between 8 percent and 9.8 percent of income, to enable them to purchase health insurance through an exchange. Employers that offer a free choice voucher are not subject to the preceding tax penalties. These provisions become effective in 2014. Finally, large employers with more than 200 employees must automatically enroll new employees in the employer’s lowest-cost plan if the employee does not enroll in a plan. Employees have the choice to opt out.

Health Insurance Exchanges Starting in 2014, the new law creates Health Insurance Exchanges in each state, a new transparent and competitive insurance marketplace where individuals and small firms with fewer than 100 employees can buy affordable and qualified health benefit plans. Access to insurance through an exchange is limited to U.S. citizens and legal residents who are not incarcerated. The various exchanges will enable people to comparison shop for standardized health insurance packages, facilitate enrollment in the various plans, and administer health-care tax credits so that people at all income levels can obtain affordable coverage. Starting in 2014, members of Congress will also get their health insurance coverage through the exchanges. Beginning in 2014, the Office of Personnel Management is required to contract with insurers to offer at least two multi-state plans in each exchange. At least one plan must be offered by a nonprofit insurer. Each multi-state plan must be licensed in each state and meet the requirements of a qualified health plan. These regional plans are a watered-down version of the public plan option, which was strongly opposed by the insurance industry and conservative members of Congress. The public plan option would have allowed the formation of a government-run health insurance plan that would compete with private insurers. The insurance industry and conservative members of Congress opposed the public option on the grounds that private insurers would be unable to compete with the government-run public plan. Because of the difficulty in getting the required number of votes in the Senate, the public plan option was stripped from the final Senate bill. The new law also creates a program of nonprofit and member-run cooperatives in all 50 states and the District of Columbia. To be eligible to receive funds, the cooperative must not be an existing health insurer or one sponsored by a state or local government. In addition, the cooperative must meet certain requirements: (1) activities of the cooperative must consist largely of the issuance of qualified health insurance plans in each state in which it is licensed; (2) governance of the cooperative must be by a majority vote of the members; and (3) any profits must be used to reduce premiums, improve benefits, or improve the quality of health care offered to the members. Once

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again, allowing cooperatives to be formed to compete with commercial insurers is an alternative to the public plan option discussed earlier.

Benefit Categories All new policies, except stand-alone dental, vision, and long-term care plans, must comply with one of four benefit categories. This requirement applies to all new plans offered through the exchanges and to plans in the individual and small group markets. Applicants have a choice of four benefit categories that cover 60 percent to 90 percent of the benefit costs, plus a separate catastrophic plan that will be offered through an exchange, and in the individual and small group markets. The benefit categories are as follows: • Bronze plan. This plan provides essential health benefits and covers 60 percent of the benefit costs. There are annual limits on out-of-pocket payments. Out-ofpocket limits refer to deductibles, coinsurance, copayments, and other cost-sharing provisions that insureds must pay. Coinsurance should not be confused with copayments. Coinsurance is a percentage of covered charges that the insured must pay, such as 25 percent of a surgeon’s fee. Copayments are flat dollar amounts, such as $25 for a doctor’s visit. In addition, the cost-sharing provisions do not apply to preventive services, and out-of-pocket payments are limited to current Health Saving Account (HSA) limits ($5,950 for an individual and $11,900 for a family in 2011. Without these limits, annual out-of-pocket payments could reach catastrophic levels and create substantial economic insecurity. • Silver plan. This plan provides essential health benefits and covers 70 percent of the benefit costs. The annual out-of-pocket limits are the same as HSA limits. • Gold plan. This plan provides essential health benefits and covers 80 percent of the benefit costs. The annual out-of-pocket limits are the same as HSA limits. • Platinum plan. This plan provides essential health benefits and covers 90 percent of the benefit costs. The annual out-of-pocket limits are the same as HSA limits. • Catastrophic plan. This plan is available only in the individual market and is limited to individuals under age 30 and to those who are exempt from the mandate to purchase coverage. This plan provides catastrophic coverage only at the coverage level set at the HSA current law levels. However, prevention benefits and three primary care visits are exempt from the deductible.

Premium and Cost-Sharing Subsidies to Individuals The new law provides premium and cost-sharing subsidies to eligible individuals that will make the coverage more affordable. Eligibility for the subsidies is limited to U.S. citizens and legal immigrants who meet the income limits. Employees who have access to health insurance through an employer’s plan are not eligible for the subsidies unless the employer’s plan does not have an actuarial value of at least 60 percent, or the employee’s share of premiums exceeds 9.5 percent of income.

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• Premium credits. The new law provides refundable and advanceable premium credits to eligible individuals and families with incomes between 133 percent and 400 percent of the federal poverty level ($43,320 for an individual to $88,200 for a family of four in 2010) to purchase insurance through the exchanges. The premium credits are based on income and are designed to limit the amount spent on health insurance from 2 percent to a maximum of 9.5 percent of income, which makes the insurance affordable. The premium credits are set on a sliding scale and range from 2 percent of income for individuals with incomes up to 133 percent of the poverty level to 9.5 percent of income for individuals with incomes between 300 percent and 400 percent of the poverty level. This provision becomes effective in 2014. • Cost-sharing subsidies. Cost-sharing subsidies that reduce the annual out-ofpocket payments for the deductibles, coinsurance, and other cost-sharing provisions are also available to eligible individuals and families. The cost-sharing credits, which are based on income, reduce the annual cost-sharing limits and increase the actuarial value of the basic benefit plan benefits. Cost-sharing credits are available to people with incomes between 100 percent and 400 percent of the poverty level. This provision becomes effective in 2014.

Premium Subsidies to Small Employers The new law contains significant tax credits for small employers to make health insurance for their employees more affordable. These provisions are summarized as follows: • Tax credits. The new law provides tax credits to small employers with fewer than 25 full-time equivalent employees and pay average annual wages of less than $50,000. This provision became effective in 2010. For tax years 2010 through 2013, a tax credit of up to 35 percent of the employer’s contribution is available if the employer contributes at least 50 percent of total premium costs. The maximum tax credit is available to employers with 10 or fewer full-time equivalent employees and pay average annual wages of less than $25,000. The maximum tax credit is phased out as the number of employees and average annual premium increase. • Increased tax credit in 2014. Beginning in 2014, the tax credit for eligible small employers that purchase health insurance through a state exchange will be increased up to 50 percent of the employer’s contribution if the employer contributes at least 50 percent of total premium costs. The full credit of 50 percent will be available to small employers with 10 or fewer employees, where average annual wages are less than $25,000. The full credit is phased out as firm size and annual average wages increase.

Early Retirement Reinsurance Program Many older employees under age 65 lose their health insurance if they retire early or are forced into retirement during a business recession. The new law creates a tempo-

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rary reinsurance program to help employers provide health insurance to early retirees over age 55 who are not eligible for Medicare. The program reimburses employers or insurers for 80 percent of retiree claims between $15,000 and $90,000. Payments from the reinsurance program will be used to reduce the costs for enrollees in the employer’s plan. This provision is now in force and applies until January 2014, when the state exchanges become fully operational.

Expansion of Medicaid The new law expands the Medicaid program to eligible individuals under age 65, including children, pregnant women, parents, and adults without dependent children, with incomes of up to 133 percent of the federal poverty level. Roughly half of the 32 million uninsured will receive coverage under state Medicaid programs and the Children’s Health Insurance Program. All newly eligible adults will be guaranteed a benchmark package of essential health benefits available through the exchanges. To finance the increase in the number of recipients, the federal government will pay 100 percent of the additional costs for 2014 through 2016, 95 percent in 2017, 94 percent in 2018, 93 percent in 2019, and 90 percent in 2020 and subsequent years.

Health Insurance Reforms The new law contains numerous provisions that apply to private health insurers to deal with the abuses and business practices discussed earlier. Individuals and families are guaranteed access to health insurance, and insurers are prohibited from denying coverage to individuals based on their health status, and from charging applicants higher premiums because of poor health or because of gender. When fully implemented, the new rules will require that new health insurance plans provide comprehensive coverage that includes at least minimum essential medical services, limits maximum out-of-pocket limits, and does not impose lifetime or annual limits on coverage. Important provisions that apply to insurers include the following: • Retention of coverage until age 26. Insurers must allow young adults to keep their insurance coverage under their parents’ policies until age 26. This provision became effective in 2010 and is especially helpful to adult children who typically lose their coverage under their parents’ policy when they graduate from college or reach a limiting age of coverage. • Prohibiting certain insurer practices. As stated earlier, depending on the year of implementation, insurers are prohibited from the following practices: (1) rescinding individual insurance policies except in cases of fraud; (2) placing lifetime limits or annual limits on coverage (prior to 2014, as stated earlier, annual limits can be imposed as determined by the secretary of Health and Human Services); (3) excluding coverage or denying claims for pre-existing conditions; and (4) using medical underwriting to exclude or rate up individuals based on health status. In addition, the policies are sold on a guaranteed issue basis and are guaranteed renewable. Variations in rating are allowed only for age, geographic area, tobacco

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use, and number of family members. Charging females higher premiums for their coverage is prohibited. • Grandfathered plans. Existing individual plans and employer-sponsored group plans generally are allowed to remain the same. All health insurance plans—whether or not they are grandfathered plans—must provide certain benefits for plan years starting on or after September 23, 2010. These benefits include (1) no lifetime limits on coverage for all plans, (2) no rescissions of coverage when people get sick and have previously made an unintentional mistake in the application, and (3) extension of parents’ coverage to young adults under age 26. In addition, employer-sponsored plans must provide additional benefits, which include (1) no pre-existing condition exclusions for children under age 19, and (2) no restricted annual limits on benefits; that is, annual dollar limits on coverage are below the standards discussed earlier. Finally, when compared to insurance policies in effect on March 23, 2010, grandfathered plans cannot significantly cut or reduce benefits, increase coinsurance charges, significantly increase deductibles and copayment charges, significantly lower employer contributions, add or tighten any annual limit on the amount the insurer pays, and change insurers and keep a grandfathered status for the new plan. • Medical loss ratio. Insurers are required to have a minimum loss ratio of 85 percent for plans in the large group market and 80 percent for plans in the individual and small group markets. The medical loss ratio refers to the percentage of total premiums that are paid for health insurance benefits and quality. Rebates must be provided to the insured if the loss ratios are not met because of high profits or high administrative expenses. Insurers must report medical loss ratios starting in plan year 2010 and provide for rebates beginning in 2011. In addition, the new law establishes a process for reviewing premium increases in health insurance plans and requires plans to justify premium increases. The states are required to report on trends in insurance premiums and recommend whether certain plans should be excluded from the Health Insurance Exchanges based on unjustified premium increases. This provision is effective beginning in plan year 2010.

Pre-Existing Condition Insurance Plan The new law created a temporary high-risk pool program, which provides affordable health insurance to individuals with pre-existing conditions until the Health Insurance Exchanges start operating in 2014. The program is called the Pre-Existing Condition Insurance Plan (PCIP) and is funded entirely by the federal government. To be eligible for coverage, an applicant must be a citizen or a lawful resident of the United States, must be uninsured for at least six months, and must have had a problem obtaining insurance due to a pre-existing condition. The majority of states had high-risk pools before the new law was enacted. However, the states have a choice of participating in the program. If a state decides not to participate, the federal government will run the program. As of July 2010, 29 states and the District of Columbia have elected to run their own programs and 21 states have chosen the federal government to administer their plan.27

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Improving Quality and Lowering Costs The new law has numerous provisions that will improve the quality of health care and lower costs. Some important provisions are summarized as follows: • Rebuilding the primary care workforce. To strengthen the availability of primary care personnel, there are new incentives to expand the number of primary care physicians, nurses, and physician assistants, which include funding for scholarships and loan repayments for primary care physicians and nurses working in underserved areas. Physicians and nurses receiving payments made under any state loan repayment or loan forgiveness program, which is intended to increase the availability of health-care services in underserved areas or in areas with a shortage of health professionals, do not have to pay taxes on those payments. This provision became effective in 2010. • Preventing disease and illness. A new $15 billion Prevention and Public Health Fund will invest in proven prevention and public health programs designed to help keep Americans healthy, including programs to quit smoking and combat obesity. This provision became effective in 2010. • Establishing a patient-centered outcomes research institute. The new law establishes a private nonprofit institute to identify national priorities and provide research that compares the effectiveness of health-care treatments and strategies. • Strengthening community health centers. The new law includes funding to support the construction of community health centers and the expansion of medical services, which will enable these centers to serve some 20 million new patients across the country. This is an important provision because community health centers are often the only affordable source of medical care to low-income and uninsured individuals. This provision became effective in 2010. • Cracking down on health-care fraud. The new law requires enhanced screening procedures for health-care providers to eliminate fraud and abuse in the health-care system. Many provisions became effective upon enactment of the new law. • Encouraging integrated health systems. The new law provides incentives for physicians to join together to form “accountable care organizations.” In these groups, doctors can better coordinate patient care and improve the quality of care, help prevent disease and illness, and reduce unnecessary hospital admissions. If an accountable care organization provides high-quality care and reduces costs to the health-care system, it can keep some of the savings, which provides a strong financial incentive to control cost. This provision becomes effective in 2012. • Reducing paperwork and administrative expenses. Health care remains one of the few industries to rely on paper records. The new law institutes a series of changes to standardize billing and requires health plans to begin adopting and implementing rules for the secure and confidential electronic exchange of health information. Electronic health records reduce paperwork and administrative burdens, cut costs, reduce medical errors, and, most importantly, improve the quality of care. The first regulation becomes effective in October 2012. • Increasing Medicaid payments for primary care physicians. Medicaid programs

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and health-care providers will be treating more patients in 2014, which is problematic. The new law requires the states to pay primary care physicians no less than 100 percent of Medicare payment rates in 2013 and 2014 for primary care services. The increase is fully funded by the federal government and becomes effective in January 2014. This is an important provision because many physicians and other health-care providers currently do not accept new Medicaid patients because of relatively low reimbursement rates. • Paying physicians based on value and not volume. A new provision ties physician payments to the quality of care they provide. Payments to physicians will be modified so that physicians who provide higher-value medical care will receive higher payments than those who provide lower-quality care. This provision becomes effective in 2015.

Cost and Financing The health-care reform legislation is expensive. The CBO estimates that the new law will extend health insurance to an additional 32 million uninsured persons and cost $938 billion over a 10-year period. Financing the new law is complex, with funding coming from several sources. Major sources of funding include: • Savings in the Medicare and Medicaid programs by reducing fraud and abuse and unnecessary tests and procedures; • Reduced payments to Medicare Advantage plans; • New annual fees on the pharmaceutical manufacturing industry and on health insurers; • New excise tax on the sale of taxable medical devices. In addition, new taxes, fees, and penalties are imposed on the following: • As discussed earlier, individuals who fail to maintain the required insurance coverage must pay a tax penalty. This provision becomes effective in 2013. • Beginning in 2018, a 40 percent excise tax will be imposed on insurers and plan administrators for high-cost health insurance plans with aggregate values that exceed $10,200 for individual coverage and $27,500 for family coverage. The tax applies to the amount of premium in excess of the threshold. The thresholds are indexed for 2019 and subsequent years. • Contributions to a flexible spending account for medical expenses are limited to $2,500 yearly, which is indexed by the Consumer Price Index for subsequent years. This provision becomes effective in 2013. • Beginning in 2013, the Hospital Insurance payroll tax will be increased 0.9 percent (from 1.45 percent to 2.35 percent) on earnings over $200,000 for single persons and $250,000 for married couples filing jointly. The additional payroll tax on high-wage earners is part of the financing provisions under the new Patient Protection and Affordable Care Act. • There is an additional tax of 3.8 percent on net investment income for taxpayers

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earning over $200,000, and for married couples earning over $250,000 who file a joint return. • The cost of over-the-counter drugs that do not require a doctor’s prescription will no longer be reimbursed by a flexible spending account or health reimbursement account. This provision becomes effective in 2013. • The tax deduction for employers who receive Medicare Part D subsidy payments for retirees is eliminated. This provision becomes effective in 2013. • The income threshold for deducting itemized medical expenses is increased from 7.5 percent to 10 percent of adjusted gross income. However, individuals over 65 could still deduct eligible medical expenses in excess of 7.5 percent of adjusted gross income through 2016. This provision becomes effective in 2013. • The amount paid for indoor tanning services is subject to a 10 percent tax. This provision became effective in July 2010. In addition, the new law contains numerous provisions that apply to the Medicare program. These provisions are designed to control rising health-care expenditures, to reduce fraud and abuse, and to make Medicare less costly and more efficient. Specific provisions dealing with Medicare are discussed in Chapter 10.

Summary • Major health problems in the United States include rising health-care expenditures, large numbers of uninsured in the population, uneven quality of medical care, considerable waste and inefficiency, defects in financing of health care, and abusive insurer practices. • Reasons for rising health-care expenditures include an increase in consumer demand, development of new technology, cost insulation because of third-party payers, employment-based health insurance, state-mandated benefits, increased spending on prescription drugs, cost shifting by health-care providers, higher administrative costs, medical inflation in the health-care sector, defensive medicine, and other factors. • Studies show that people are uninsured because health insurance is too expensive to purchase; many uninsured people have been unable to get coverage, or insurers have refused to insure them because of poor health, illness, or age; some people believe that health insurance is not needed; and others lack knowledge on how to get insurance. Also, many low-income people who are eligible for Medicaid coverage fail to sign up because they are unaware they are eligible; some people with high incomes do not purchase health insurance because they view it as a low priority; and many younger people are healthy and believe that insurance is unnecessary. • The traditional fee-for-service system often works in a perverse way. Under this system, physicians are compensated based on the number of medical services provided and not on the medical outcomes of their patients. The more services and tests that physicians provide, the higher their incomes. The fee-for-service system may also encourage some physicians to provide unnecessary medical tests and treatment. • Congressional hearings revealed that many insurers were engaging in questionable

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business practices and abuses that were harmful to insured patients. Some insurers denied legitimate claims because of a pre-existing condition not disclosed in the application; some rescinded individual policies to avoid paying large claims; some insureds were forced into bankruptcy because of inadequate lifetime or annual limits; there were sizable variations in premiums in the underwriting of individual policies; females were charged substantially more for health insurance than males; and when only age and health status were considered, some persons were charged substantially more for the same type of coverage than others. • Beginning in 2014, most citizens and legal residents in the United States must have qualifying health insurance or pay a tax penalty. • Employers are not required to provide health insurance to their employees. Larger employers, however, are assessed a penalty if they do not provide health insurance to covered employees. The law specifically exempts employers with fewer than 50 full-time employees. • Starting in 2014, the new law creates Health Insurance Exchanges in each state through which individuals and small firms with fewer than 100 employees can buy affordable and qualified health benefit plans. • Applicants will have a choice of four benefit categories that cover 60 percent to 90 percent of the benefit costs, plus a separate catastrophic plan that will be offered through an exchange, and in the individual and small group markets. • To make health insurance affordable, premium credits are provided to eligible individuals and families with incomes between 133 percent and 400 percent of the federal poverty level. • Subsidies are also available, based on income, that reduce the annual out-of-pocket payments for deductibles, coinsurance, and other cost-sharing provisions. • The new law provides tax credits to small employers with fewer than 25 full-time equivalent employees and pay average annual wages of less than $50,000. For tax years 2010 through 2013, a tax credit of up to 35 percent of the employer’s contribution is available if the employer contributes at least 50 percent of total premium costs. The full credit is available to employers with 10 or fewer fulltime equivalent employees and pay average annual wages of less than $25,000. The maximum tax credit increases to 50 percent in 2014. • The new law creates a temporary reinsurance program to help employers provide health insurance to early retirees over age 55 who are not eligible for Medicare. The program reimburses employers or insurers for 80 percent of retiree claims between $15,000 and $90,000. • The new law expands the Medicaid program to eligible individuals under age 65 with incomes of up to 133 percent of the federal poverty level. • Insurers must allow dependent children to stay covered under their parents’ policies until age 26. Insurers are prohibited from the following: rescinding individual policies except in cases of fraud; placing lifetime limits or annual limits on coverage; excluding coverage for pre-existing conditions; and using medical underwriting to rate up or exclude individuals based on health status. Some provisions will not become fully effective until 2014.

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• Existing individual plans and employer-sponsored group plans that are grandfathered generally are allowed to remain the same. However, grandfathered plans must provide certain benefits for plan years starting on or after September 23, 2010. These benefits include (1) no lifetime limits on coverage for all plans, (2) no rescissions of coverage when people get sick and have previously made an unintentional mistake in the application, and (3) extension of parents’ coverage to young adults under age 26. In addition, employer-sponsored plans must provide additional benefits, which include (1) no pre-existing condition exclusions for children under age 19, and (2) no restricted annual limits on benefits, that is, annual dollar limits on coverage are below the standards discussed earlier. • Insurers must have a minimum medical loss ratio of 85 percent for plans in the large group market and 80 percent for plans in the individual and small group markets or provide rebates to the insured if the loss ratios are not met. • The new law creates a temporary high-risk pool program, which provides affordable health insurance to individuals with pre-existing conditions until the exchanges start operating in 2014. The program is called the Pre-Existing Condition Insurance Plan and is funded entirely by the federal government. • Provisions that may improve the quality of care or lower costs include rebuilding the primary care workforce; preventing disease and illness; funding to support the construction or expansion of community health centers; providing incentives for physicians to form Accountable Care Organizations; reducing paperwork and administrative expenses; increasing Medicaid payments for primary care physicians; and paying physicians based on value and not volume. • Major sources of financing include savings in Medicare and Medicaid; reduced payments to Medicare Advantage plans; new annual fees on the pharmaceutical manufacturing industry and on health insurers; and a new excise tax on the sale of taxable medical devices. Also, there are numerous new taxes and fees. Beginning in 2018, a 40 percent excise tax is imposed on insurers and plan administrators for high-cost health insurance plans with aggregate values that exceed $10,200 for individual coverage and $27,500 for family coverage. The Medicare Hospital Insurance payroll tax is increased 0.9 percent (from 1.45 percent to 2.35 percent) on earnings in excess of $200,000 annually for individuals and $250,000 for married couples filing jointly. There is an additional tax of 3.8 percent on net investment income for taxpayers earning over $200,000 ($250,000 for married couples filing a joint return).

Review Questions 1. Identify the major health-care problems in the United States that led to the enactment of the Patient Protection and Affordable Care Act. 2. Why have total health-care expenditures in the United States increased over time? 3. List several examples of waste and inefficiency in the present health-care delivery system.

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4. Explain the reasons why large numbers of Americans have no health ­insurance. 5. Identify several abusive business practices of health insurers that resulted in health-care reform legislation. 6. Explain briefly the following provisions of the Patient Protection and Affordable Care Act: a. Coverage requirements b. Employer requirements c. Health insurance exchanges d. Benefit categories e. Subsidies and tax credits 7. Explain briefly the major defects in the fee-for-service method of compensating physicians. 8. Explain briefly the major health insurance reforms under the Patient Protection and Affordable Care Act. 9. Explain the basic characteristics of the Pre-Existing Condition Insurance Plan. 10. Identify several provisions in the 2010 health-care reform law that may improve the quality of care or lower costs.

Application Questions 1. Ken, age 52, works only part-time and has no health insurance. The cartilage in both his knees is severely eroded from osteoarthritis, which causes severe pain during his daily activities. As a result, Ken requires major surgery and a total knee replacement for both knees. He has been unable to obtain health insurance because of this condition. Explain one or more provisions in the new health-care reform law that might enable Ken to obtain health insurance. 2. Dave, age 58, is the owner of a small firm that sells window blinds and cleans carpets. The company provides health insurance for seven employees. The wife of one employee has breast cancer and has incurred substantial medical bills, which resulted in a 40 percent increase in health insurance premiums for the company. Dave is not certain that the company can continue to provide health insurance for the employees because of the substantial increase in premiums. Describe one or more provisions in the new health-care reform law that might assist Dave in providing affordable health insurance to his employees. 3. Brandon, age 32, is married and has a son, age one. Six months ago, Brandon purchased an individual health insurance policy covering the entire family. His son was recently diagnosed with congenital heart disease. When Brandon submitted the medical bill for his son’s treatment, the insurer attempted to deny payment on the grounds that Brandon had concealed his son’s heart condition because the condition was not disclosed in the application at the time the policy was purchased. Can the insurance company legally deny payment of the claim? Explain your answer. 4. Megan, age 24, recently graduated from college. She was insured as a depen-

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dent under her father’s group health insurance policy, which provided coverage for her as a student until she graduated. However, she has been unable to find a job because of a soft labor market and high unemployment in the city where she lives. She is worried that if she becomes sick or injured, she will have no health insurance coverage to pay her bills. Identify the provision in the new health-care reform bill that will enable Megan to keep her insurance.

Internet Resources • America’s Health Insurance Plans (AHIP) is a national association that represents nearly 1,300 member companies providing health-care benefits to more than 200 million Americans. AHIP’s principal purpose is to represent the interests of its members on legislative and regulatory issues at the federal and state levels, and with the media, consumers, and employers. AHIP provides information and services, such as newsletters, publications, a magazine, and online services, and conducts education, research, and quality assurance programs. Visit the site at www.ahip.org • Families USA works to promote high-quality affordable health care for all Americans. The site provides timely information on the new Affordable Care Act and the problems Americans face in paying for medical bills. Visit the site at www.familiesusa.org • HealthCare.gov is the official Web site of the federal government that provides detailed information on the new health-care reform law and its implementation. Click on “Understanding the New Law” for a convenient source of information concerning the numerous provisions. Visit the site at www.healthcare.gov • The Henry J. Kaiser Family Foundation is one of the best sources of information concerning the new Affordable Care Act and related topics on health insurance. Visit the site at www.kff.org • HealthGrades is the leading health-care rating organization that provides ratings and profiles of hospitals, nursing homes, and physicians to consumers, corporations, health plans, and hospitals. Visit the site at www.healthgrades.com

Selected References American Medical News. “Most Metro Areas Dominated by One or Two Health Insurers.” March 9, 2009. Available at www.amednews.com Blue Cross and Blue Shield Association. Healthcare Trends in America: A Reference Guide. 2010 edition. Center for American Progress. “Health Care Competition: Insurance Market Domination Leads to Fewer Choices.” Washington, DC, June 2009. Available at www.americanprogress.org/issues/2009/06/ health_competition_map.html Centers of Medicare and Medicaid Services, Office of the Actuary. “National Health Projections, 2009–2019.” Cohen, Robin A., Michael E. Martinez, and Brian W. Ward, Centers for Disease Control and Prevention, National Center for Health Statistics. Health Insurance Coverage: Early Release of Estimates from the National Health Interview Survey, 2010. June 2011. Congressional Budget Office. Key Issues in Analyzing Major Health Insurance Proposals. Washington, DC, December 2008.

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Notes

———. Technological Change and the Growth of Health Care Spending. Washington, DC, January 2008. Families USA Foundation. “Lives on the Line: The Deadly Consequences of Delaying Health Reform.” Washington, DC, February 2010. ———. “New Report Finds 86.7 Americans Were Uninsured at Some Point in 2007–2008.” Press release, March 4, 2009. HealthCare.gov. “Provisions of the Affordable Care Act, by Year.” 2010. Available at www.healthcare .gov/ Henry J. Kaiser Family Foundation. “Family Health Premiums Rise 3 Percent to $13,770 in 2010, But Workers’ Share Jumps 14 Percent as Firms Shift Cost Burden; About One in Four Covered Workers Now Face Annual Deductibles of $1,000 or More, Including Nearly Half of Those Employed by Small Businesses.” News release, September 2, 2010. ———. “Summary of New Health Care Reform Law.” April 15, 2011. New York Times. “Editorial: End to Rescission, and More Good News.” May 2, 2010. Available at www.nytimes.com Sisko, Andrea M., Christopher J. Truffer, Sean P. Keehan, John A. Poisal, M. Kent Clemens, and Andrew J. Madison. “National Health Spending Projections: The Estimated Impact of Reform Through 2019.” Health Affairs, October 2010, pp. 1–9. U.S. Bureau of the Census. Income, Poverty, and Health Insurance Coverage in the United States: 2010. Washington, DC, September 2011. U.S. Department of Health and Human Services. “HHS Secretary Sebelius Announces New Pre-Existing Condition Insurance Plan.” News release, July 1, 2010. U.S. Government Accountability Office. Private Health Insurance: Research on Competition in the Insurance Industry. GAO-09-864R, July 31, 2009. U.S. House of Representatives, Committee on Energy and Commerce. “Coverage Denials for Pre­Existing Conditions in the Individual Health Insurance Market.” Memorandum, October 12, 2010. ———. “Maternity Coverage in the Individual Health Insurance Market.” Memorandum, October 12, 2010. U.S. Senate. “Implementation Timeline.” Patient Protection and Affordable Care Act of 2010. Available at http://dpc.senate.gov/healthreformbill/healthbill65.pdf

1. David U. Himmelstein, Deborah Thorne, Elizabeth Warren, and Steffie Woolhandler, “Medical Bankruptcy in the United States, 2007: Results of a National Study.” American Journal of Medicine 122, no. 8 (August 2009): 741–746. 2. Centers of Medicare and Medicaid Services, Office of the Actuary, National Health Projections 2009–2019, Table 1. 3. Blue Cross and Blue Shield Association, Healthcare Trends in America: A Reference Guide from BCBS (2009 edition), p. 18. 4. Wikipedia, “List of Countries by Life Expectancy.” Data are from CIA World Factbook (2011 estimates). 5. George E. Rejda, Principles of Risk Management and Insurance. 11th ed. (Boston: Pearson Education, 2011), pp. 310–311. 6. Congressional Budget Office, Technological Change and the Growth of Health Care Spending (Washington, DC, January 2008). 7. Blue Cross and Blue Shield Association, Healthcare Trends in America, p. 21. 8. Ibid. 9. Insurance Research Council, “Hospital Cost Shifting Adds to Auto Injury Claim Costs.” News release, April 22, 2010. 10. Blue Cross and Blue Shield Association. Healthcare Trends in America, p. 21. 11. Congressional Budget Office, Technological Change and the Growth of Health Care Spending.

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12. Ibid. 13. Kaiser Family Foundation, “Six in Ten Say Family Put Off Medical Care Due to Cost.” News release, April 23, 2009. 14. U.S. Bureau of the Census, Income, Poverty, and Health Insurance Coverage in the United States: 2010. Washington, DC, September 2011. 15. Henry J. Kaiser Family Foundation, The Uninsured, A Primer: Supplementary Data, Tables, Table 9, October 2009. 16. Centers for Disease Control and Prevention, National Center for Health Statistics, Health Insurance Coverage: Early Release of Estimates from the National Health Interview Survey, 2010, June 2011. 17. Families USA, Lives on the Line: The Deadly Consequences of Delaying Health Reform, February 2010. 18. NPR/Kaiser Foundation/Harvard School of Public Health, Summary & Chartpack, The Public and the Health Care Delivery System, April 2009. 19. NCQA, “Report: Health Care Quality Improves But Varies Across Different Regions of the Country.” News release, October 2, 2008. 20. Center for American Progress, Health Care Competition: Insurance Market Domination Leads to Fewer Choices, June 2009. 21. American Medical Association, American Medical News, “Most Metro Areas Dominated by One or Two Health Insurers,” March 9, 2009. Available at www.amednews.com. 22. House of Representatives, Committee on Energy and Commerce, “Coverage Denials for PreExisting Conditions in the Individual Health Insurance Market.” Memorandum, October 12, 2010; and “Maternity Coverage in the Individual Health Insurance Market.” Memorandum, October 12, 2010. 23. “Editorial: End to Rescission, and More Good News,” New York Times, May 2, 2010. Available at www.nytimes.com 24. Himmelstein, Thorne, Warren, and Woolhandler, “Medical Bankruptcy in the United States, 2007.” 25. Families USA, Empty Promise: Searching for Health Insurance in an Unfair Market, August 2008. 26. This section is based primarily on Henry J. Kaiser Family Foundation’s Summary of New Health Care Reform Law, April 15, 2011; www.healthcare.gov, “Provisions of the Affordable Care Act, By Year,” 2010; and U.S. Senate, “Implementation Timeline,” Patient Protection and Affordable Care Act, 2010. 27. U.S. Department of Health and Human Services, “HHS Secretary Sebelius Announces New Pre-Existing Condition Insurance Plan.” News release, July 1, 2010. Available at www.HHS.gov

9 Health-Care Reform and Private Health Insurance

Student Learning Objectives After studying this chapter, you should be able to: • Identify the major changes to individual and group medical expense coverage under the new Affordable Care Act. • Describe the basic characteristics of the following types of individual coverage: – Major medical insurance – Health savings accounts (HSAs) – Long-term care insurance – Disability income insurance • Describe the major characteristics of the following managed care plans: – Health maintenance organization (HMO) – Preferred provider organization (PPO) – Point of service plan (POS) • Explain the major characteristics of the following consumer-directed health plans: – Defined-contribution plans – High deductible plans • Describe the current developments in group health insurance. • Describe the major characteristics of group disability income plans. Most individuals and families rely heavily on both individual and group health insurance coverage to pay their medical bills when sick or injured. Individual and group coverage have been significantly affected by the new Patient Protection and Affordable Care Act enacted in 2010. In this chapter, we discuss major individual and group health coverage under the new law. This chapter is divided into three major parts. The first part summarizes the major changes to individual and group medical expense coverage under the new health-care reform law. The second part discusses types of major individual health insurance coverage that are sold today. The third 195

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part discusses major group health insurance coverage and current developments in group medical expense plans.

Impact of Health-Care Reform on Individual and Group Coverage Before proceeding, it is important to understand the major changes to individual and group medical expense coverages under the Affordable Care Act. Although these provisions have already been discussed in Chapter 8, they are included here because of their importance. The new health-care reform law will be phased in from 2010 through 2018. Some changes became effective in 2010 when the new law was enacted, while other major changes will become effective in 2014. Important provisions in the new law that affect individual and group coverages discussed in this chapter are summarized as follows: • Individual mandate. Beginning in 2014, most people in the United States must have health insurance that meets certain minimum standards or else pay a tax penalty. Compulsory insurance reduces adverse selection against insurers and cost shifting by health-care providers for treating uninsured patients. • Elimination of lifetime limits. Individual and group plans are prohibited from placing lifetime dollar limits on the value of the coverage. • Restrictions on annual limits. Prior to 2014, the new law restricts and phases out any annual dollar limits on covered benefits that may be present in group plans and in individual health insurance as determined by the Secretary of Health and Human Services. Beginning in 2014, annual limits on coverage are prohibited. • Exclusions for pre-existing conditions for children not allowed. Excluding coverage or denying claims for pre-existing conditions for children under age 19 and for adults beginning in 2014 is not allowed. • Retention of coverage for young adults until age 26. Young adults must be allowed to retain coverage under their parents’ policies until age 26. • Rescission of individual contracts not allowed. Insurers are prohibited from rescinding individual insurance policies except in the case of fraud. Insurers earlier could deny claims on the basis of technical irregularities or mistakes in the application when the policy was first underwritten. • Restrictions on rating variables. Beginning in 2014, variations in rating are allowed only for age, geographical area, tobacco use, and number of family members, and charging females higher premiums for their coverage is prohibited. • Benefit categories. Applicants will have a choice of bronze, silver, gold, or platinum plans that cover 60 percent to 90 percent of the benefit costs, plus a separate catastrophic plan that will be offered through a Health Insurance Exchange, and in the individual and small group markets. • No cost-sharing provisions for preventive services. New plans that start on or after September 23, 2010, and existing plans that make changes after that date

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cannot impose deductibles, coinsurance, and copayments on preventive services such as mammograms, colonoscopies, and cancer screenings. • Medical loss ratios. Insurers are required to have a minimum loss ratio of 85 percent for plans in the large group market and 80 percent for plans in the individual and small group markets. • Premium credits to individuals and families. Premium credits will be provided to eligible individuals and families with incomes of 133 percent to 400 percent of the federal poverty level to enable them to buy health insurance through the Health Insurance Exchanges. The premium credits are designed to limit the amount spent on health insurance from 2 percent to a maximum of 9.5 percent of income. This provision becomes effective in 2014. • Tax credits to small employers. The new law provides tax credits to small employers that have fewer than 25 full-time equivalent employees and pay average annual wages of less than $50,000. • Employer penalties. The new law does not require employers to offer health insurance to their employees. However, employers with 50 or more employees that do not offer coverage to their employees, where at least one employee is receiving a premium tax credit through a Health Insurance Exchange, will be assessed an annual fee of $2,000 for each full-time employee (in excess of 30 employees).

Individual Health Insurance Coverages Millions of people are covered under individual health insurance plans. Many workers are laid off, fired, or retire early and need individual coverage; many unemployed workers are between jobs and need individual insurance; children who attain age 26 are no longer covered under their parents’ plans and may need individual insurance; the self-employed who are not in group plans may require individual coverage; and a high percentage of people who are not in the paid labor force require individual protection. In addition, most workers need disability income insurance if they become sick or injured, and most retired persons need long-term care insurance. In this section, we discuss the following kinds of individual coverages.1 • Major medical insurance • Health savings accounts • Disability income insurance • Long-term care insurance

Major Medical Insurance Most individual medical expense plans sold today are major medical policies. ­Major medical insurance is a plan that pays a high percentage of covered expenses incurred by insured individuals when they have a catastrophic illness or injury. The primary purpose is to relieve the insured of the crushing financial burden of a catastrophic loss. A typical individual major medical policy sold today has the following ­characteristics:

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• Catastrophe benefits • Broad range of benefits • Deductible • Coinsurance • Out-of-pocket limits • Exclusions Catastrophe Benefits

Major medical insurance is not designed to pay first-dollar coverage, but to pay catastrophic medical bills that can cause great economic insecurity. Because of the high cost of medical care, it is not uncommon for patients to incur medical bills of $50,000, $100,000, $500,000, or even higher amounts. Major medical policies are designed to pay a large part of these expenses. As stated earlier, lifetime dollar limits on benefits are no longer permitted. This limitation applies to both existing and new major medical plans. Broad Range of Benefits

Major medical policies provide a broad range of benefits. New major medical plans must meet minimum benefit standards to be sold on the various exchanges. Benefits typically include the following: • Inpatient hospital services. Inpatient services include room and board charges for the hospital room, meals, routine nursing care, and other services. Other covered inpatient services include charges for the operating room, surgical dressings, drugs, lab tests, X-rays, and radiology services. • Outpatient services. Coverage for outpatient services typically includes surgery as an outpatient in a hospital or separate outpatient facility; pre-admission tests given prior to admission into the hospital as an inpatient; outpatient chemotherapy and radiation therapy; outpatient services provided in an emergency room; and other services as well. • Physicians’ services. Major medical plans typically cover office visits to physicians, consultation with specialists, surgeons’ fees, cost of anesthesia services, and services provided by chiropractors, physician assistants, nurse practitioners, physical therapists, and other therapists. Surgeons and other physicians are commonly reimbursed on the basis of reasonable and customary charges, which vary by insurer. For example, an insurer may consider a surgeon’s fee to be reasonable and customary if it does not exceed the 80th or 90th percentile for a similar procedure performed by other surgeons in the same area. In most cases, the surgeon’s actual fee will be substantially above the reasonable and customary charge. The allowable charge, however, is the lower of the surgeon’s actual fee or the reasonable and customary charge. With the exception of managed care plans discussed later, the insured must pay that portion of the fee that exceeds the upper limit.

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• Outpatient prescription drugs. Outpatient prescription drug coverage is another important benefit. There are two ways to provide coverage for prescription drugs.2 First, under the integrated approach, charges for prescription drugs are subject to the same deductible and coinsurance charges that apply to other covered medical expenses. Second, under a separate drug card program, prescription drugs are subject to their own deductible and copayment charges. The drug card program is usually administered by a third-party administrator, such as a benefit pharmacy manager. A three-tier or fourtier system of pricing is commonly used. For the first tier, the copayment charge is the lowest for generic drugs. For the second tier, the copayment charge is higher for brandname drugs on an approved list (called a formulary). For the third tier, the copayment charge is even higher for brand-name drugs that are not on the formulary. Finally, for the fourth tier, some plans may include coverage for very expensive drugs; copayments and coinsurance charges are substantially higher for drugs in this category. Deductible

A major medical policy typically contains a deductible that must be satisfied before any benefits are paid. Deductibles in policies sold today are much higher than in policies sold in previous years. The insured usually has a choice of deductibles. Typical deductibles are $500, $1,000, $1,500, $2,000, or some higher amount. The purpose of the deductible is to eliminate small claims and the high administrative cost of processing them. By eliminating small claims, insurers can provide high limits and still keep the premiums reasonable. Most major medical policies have a calendar-year deductible. A calendar-year deductible is an aggregate deductible that has to be satisfied only once during the calendar year. All covered medical expenses incurred by the insured during the calendar year can be applied toward the deductible. Once the deductible is met, no additional deductible has to be satisfied during the calendar year. To avoid paying two deductibles in a short time, most plans have a carryover provision, which means that unreimbursed medical expenses incurred during the last three months of the calendar year and applied to that year’s deductible can be carried over and applied to following year’s deductible. Finally, under the new health-care reform law, deductibles and other cost-sharing provisions do not apply to preventive services. All new individual and group health plans must provide first dollar coverage for preventive services. This provision became effective in 2010. Coinsurance

Major medical policies contain a coinsurance provision, which requires the insured to pay a certain percentage of eligible expenses in excess of the deductible. Coinsurance should not be confused with copayment. Coinsurance refers to the percentage of the bill in excess of the deductible, which the insured must pay. Copayment is a flat amount that the insured must pay for certain benefits, such as $25 for a visit to a primary care physician, or a $10 copayment fee for a generic drug.

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Coinsurance provisions typically require the insureds to pay 20 percent, 25 percent, or 30 percent of covered medical expenses that exceed the deductible. For example, assume that an insured person has covered medical expenses of $10,000, the calendar year deductible is $1,000, and the coinsurance percentage is 20 percent. In addition to the $1,000 deductible, the insured pays 20 percent of the excess, or $1,800 (20 percent x $9,000). The insurer pays the remainder, or $7,200. The coinsurance provision has two basic purposes: (1) to reduce premiums, and (2) to prevent overutilization of plan benefits. Coinsurance has a powerful impact on reducing premiums, and the insured are less likely to demand unnecessary services if they pay part of the cost. Annual Out-of-Pocket Limits

Major medical policies also contain an annual out-of-pocket limit (also called a stoploss limit) by which 100 percent of the covered medical expenses in excess of the deductible are paid after the insured pays a certain annual amount of out-of-pocket expenses. The purpose of the annual out-of-pocket limit is to reduce the crushing financial burden of a catastrophe loss. The insured is usually given a choice of annual out-of-pocket limits when the policy is purchased, such as $3,000, $4,000, or some higher amount. Out-of-pocket limits for family policies are substantially higher. Exclusions

All individual major medical policies contain exclusions. Some common exclusions are as follows: • Expenses caused by war • Elective cosmetic surgery • Eyeglasses and hearing aids • Dental care, except as a result of an accident • Expenses covered by workers’ compensation and similar laws • Unnecessary treatment or experimental medical treatment • Services furnished by governmental agencies unless the patient has an obligation to pay • Expenses covered by Medicare or other government medical expense programs • Expenses resulting from suicide or self-inflicted injury

Major Medical Insurance and Managed Care Many individual major medical policies sold today are part of a managed care plan. Managed care is a generic term for medical expense plans that provide benefits to insured individuals in a cost-effective manner. There is heavy emphasis on controlling costs and providing benefits to plan members in a cost-effective manner. For example, a preferred provider organization (PPO) is a popular type of managed care plan for both individual and group health insurance plans. A PPO contracts with physicians,

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hospitals, and other health-care providers to provide medical services to the members at discounted fees. People insured under a PPO have a strong financial incentive to receive care from preferred providers because of lower deductibles and coinsurance charges. Those who receive care outside the network must pay higher out-of-pocket costs because of substantially higher deductibles and coinsurance charges. PPOs and other managed care plans are discussed in greater detail later in the chapter. Individual major medical policies today have incorporated many elements of managed care in the plan design. For example, the plan may require precertification and approval for nonemergency admission into a hospital; certain types of surgery must be done on an outpatient basis; and an insured may be required to use health-care providers who are part of the network or pay higher-out-of pocket costs for the benefits received. Managed care is discussed in greater detail later in the chapter.

Health Savings Accounts A health savings account (HSA) is a tax-exempt or custodial account established exclusively for the purpose of paying qualified medical expenses of the account beneficiary who is covered under a high-deductible health insurance plan. Health savings accounts have two components: (1) a high-deductible health insurance policy that covers catastrophic medical bills, and (2) an investment account from which the account holder can withdraw money tax free for qualified medical expenses. • Eligibility requirements. Several eligibility requirements must be fulfilled to receive favorable tax treatment. First, the insured must be under age 65 and be covered by a high-deductible health plan and must not be covered by any other qualified high-deductible plan. This requirement does not apply to accident insurance, disability insurance, long-term care insurance, auto insurance, and certain other coverages. Second, the individual must not be eligible for Medicare. Finally, the insured must not be claimed as a dependent on another person’s tax return. • High-deductible health plan. For 2011, the annual deductible must be at least $1,200 for an individual and $2,400 for family coverage. The deductible cannot be applied to preventive services and is indexed annually for inflation. There is a maximum limit on annual out-of-pocket expenses. For 2011, annual out-of-pocket expenses, including the deductible and other cost-sharing provisions, cannot exceed $5,950 for an individual and $11,900 for a family. The annual outof-pocket limits are adjusted each year for inflation. In addition, an HSA may also have a coinsurance requirement. Although some HSA plans pay 100 percent of the covered expenses exceeding the deductible, many individuals prefer to pay a lower premium for a policy with a coinsurance requirement. The coinsurance percentage is typically 20 percent, 25, percent or 30 percent of the covered costs in excess of the deductible up to some maximum annual limit. If the insured person receives care outside of a preferred provider network, coinsurance and copayment charges are substantially higher. • Annual contribution limits. HSA contributions can be made by the insured, his or her employer, and family members. For 2011, annual contributions for individual

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coverage are limited to $3,050 for individual coverage and $6,150 for family coverage. These amounts are adjusted annually for inflation. Insured individuals age 55 or older can make an additional catch-up contribution of $1,000. • Favorable income-tax treatment. The investment account in a qualified HSA plan receives favorable income-tax treatment. Annual premiums are income-tax deductible up to the limits described earlier. The deduction is “above the line,” which means the insured person does not have to itemize deductions on the tax return to receive the deduction. In addition, investment earnings accumulate income-tax free, and distributions from the account are not taxable if used to pay qualified medical expenses. If the distributions are used for nonmedical purposes, they are taxable as ordinary income, and a 10 percent penalty must also be paid. Once the insured person attains age 65, additional contributions cannot be made, but the funds can still be used to pay for qualified medical expenses. The funds can be used for nonmedical purposes, however, but the money used is taxable income. • Rationale for HSAs. Proponents present several arguments for HSAs: (1) if consumers must pay more for health care out of pocket, they will be more sensitive to health-care costs, avoid unnecessary medical services, and shop around for health care; (2) health insurance will be more affordable because of lower premiums; (3) if not needed for medical expenses, funds in an HSA can be used for retirement; and (4) HSAs are portable, which means workers can keep their insurance if they change jobs or become unemployed. Critics of HSAs, however, present the following counterarguments: (1) HSA premiums are lower only because a significant part of the initial medical bill is shifted to the insured; (2) low-income persons and many middle-income workers and families cannot afford to pay the high annual deductible and coinsurance payments until coverage begins; (3) shopping around for less expensive health care is not practical or even possible for sick or injured persons, who may require immediate medical care, and easily accessible and reliable cost information may not be available; and (4) because of lower premiums, HSAs are more appealing to younger and healthier people who may opt out of coverage in traditional plans, which dilutes the number of healthy people in the insurance pool and raises premiums for unhealthy members.

Disability Income Insurance Disability income insurance provides monthly cash benefits to an insured individual who is totally disabled due to sickness or injury. The objective is to replace part of the loss of earnings due to the disability. The probability of becoming disabled before retirement is higher than is commonly believed. According to the Social Security Administration, studies show that a 20-year-old worker has a 3 in 10 chance of becoming disabled before reaching retirement age.3 In cases of long-term disability, earned income is lost, medical expenses must be paid, savings are often depleted, employee benefits may be lost or reduced, and someone must care for a permanently disabled person. Unless there is adequate replacement income during the period of disability, considerable economic insecurity is present.

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Individual disability income policies have several key characteristics. The most important are summarized as follows: • Meaning of disability. There are several definitions of total disability. Disability can be defined as (1) the inability to perform all duties of the insured’s own occupation; (2) the inability to perform the duties of any occupation for which the insured is reasonably fitted by training, education, and experience; (3) the inability to perform the duties of any gainful occupation, which may be found in policies that insure hazardous occupations; and (4) a loss-of-income test, which considers the actual loss of earned income as an objective measure of disability. Many policies combine the first two definitions. For some initial time period, such as two to five years, total disability is defined in terms of the insured’s own occupation. After the initial period of disability expires, the second definition applies. For example, assume that a dentist can no longer practice because of severe arthritis in his or her hands. For the first two years, the dentist would be considered totally disabled. However, after two years, if the dentist could work as a research scientist, or as an instructor in a dental school, or in a similar occupation, he or she would no longer be considered disabled because these occupations are consistent with the dentist’s training, education, and experience. Finally, the policy may also contain a definition of presumptive disability. Total disability is presumed to exist if the insured suffers the total and irrevocable loss of sight in both eyes, or the total loss or use of both hands, both feet, or one hand and one foot. • Partial disability. Some disability income policies may pay partial disability benefits. Partial disability is defined as the inability of the insured to perform one or more important duties of his or her occupation. Partial disability benefits are paid at a reduced rate for a shorter period. Partial disability benefits generally must follow a period of total disability. For example, a person may be totally disabled for several months after a serious auto accident. If the person recovers and goes back to work on a part-time basis to see if recovery is complete, partial disability benefits can be paid. • Residual disability. Newer policies may contain a residual disability definition, rather than a partial disability provision, or coverage for residual disability can be added as an additional benefit with a higher premium. Residual disability means that a pro rata disability benefit is paid to an insured person whose earned income is reduced because of an accident or sickness. For example, if the insured’s earned income is reduced 25 percent during some measurable time period because of sickness or injury, 25 percent of the monthly disability benefit will be paid. • Benefit period. The insured has a choice of benefit periods, such as 2, 5, or 10 years, or up to age 65 or 70. The vast majority of disabilities are under two years. However, this does not mean that a two-year benefit period is adequate. The longer the disability, the less likely the disabled person will recover. For example, 10 percent of the people who are disabled for at least 90 days will be disabled for 5 or more years.4 Thus, because of uncertainty concerning the duration of disability, a longer benefit period is desirable—ideally, one that pays benefits to age 65 or 70. • Elimination period. Disability income policies are typically sold with an elimination period (waiting period) during which time benefits are not paid. Insurers offer

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a range of elimination periods, such as 30, 60, 90, 180, or 365 days. The longer the elimination period, the greater is the reduction in premiums. However, an elimination period beyond six months is not advisable, because the reduction in premiums is relatively small. • Waiver of premium. Most policies contain a waiver-of-premium provision, by which premiums are waived if the insured is totally disabled for at least 90 days. If the insured recovers from the disability, premium payments must be resumed. • Rehabilitation provision. The insurer and insured may agree on a vocational rehabilitation program. To encourage rehabilitation, part or all of the disability income benefits are paid during the training period. At the end of training, if the insured is still disabled, benefits continue as before. If the individual is fully rehabilitated and is capable of returning to work, the benefits will terminate. • Accidental death, dismemberment, and loss-of-sight benefits. In the case of an accident, some policies pay accidental death, dismemberment, and loss-of-sight benefits. The maximum amount paid is called the principal sum, and the amounts paid are based on a schedule. For example, the principal sum may be payable for the loss of both hands and both feet or sight of both eyes. • Optional disability income benefits. Several optional benefits can be added to a disability income policy by payment of higher premiums. They include the following: (1) a cost-of-living rider by which disability benefits are periodically adjusted for increases in the cost of living; (2) option to purchase additional insurance by which disability benefits can be increased at specific times in the future with no evidence of insurability; (3) Social Security rider by which an additional amount is paid if the insured is turned down for Social Security disability benefits; and (4) return of premiums rider by which part of the premium is refunded, such as 80 percent of the premiums paid, less any claims, after 10 years.

Long-Term Care Insurance Many older Americans will spend some time in a nursing home. According to the U.S. Department of Health and Human Services, people who reach age 65 will likely have a 40 percent chance of entering a nursing home. About 10 percent of the people who enter a nursing home will stay there five years or more.5 The cost of long-term care is staggering. Depending on location, long-term care facilities charge $70,000 to $100,000 or even more for each year of care. As a result, many older Americans purchase long-term care policies to meet the financial burden of an extended stay. As stated in Chapter 4, long-term care policies generally have the following ­characteristics6: • Several types of policies. There are generally three types of policies. A facilityonly policy covers care in a nursing facility, assisted living facility, and other facilities. A home health-care policy covers care received outside of a facility. Finally, a comprehensive policy covers care both in a nursing facility and other facilities, and also makes home health care available on an optional basis.

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• Guaranteed renewable. The contracts are guaranteed renewable. Once issued they cannot be canceled, but rates can be increased for broad classes of ­insureds. • Choice of daily benefits. Applicants can select the level of daily coverage desired, such as $300 daily and a maximum benefit period of three years. • Elimination period. Coverage can be purchased with an elimination period, which is a waiting period during which time benefits are not paid. Common elimination periods are 30, 60, 90, or 180 days. • Benefit triggers. The insured person must meet one of two benefit triggers to receive benefits. The first trigger requires the insured to be unable to perform a certain number of activities of daily living (ADLs), which typically are eating, bathing, dressing, transferring from a bed to a chair, using the toilet, and being continent. The second trigger is that the insured has a severe cognitive impairment and needs supervision. The person might have Alzheimer’s disease, severe memory impairment, or becomes disoriented and need protection. • Inflation protection. Some type of inflation protection can be added as an optional benefit. Many insurers allow insured customers to increase the daily benefit each year based on increases in the Consumer Price Index (CPI). Another method is to automatically increase the initial daily benefit each year at some specified rate, such as 5 percent annually. Adding an automatic benefit increase, however, is expensive and will increase the annual premiums significantly. • Nonforfeiture benefits. Most insurers offer optional nonforfeiture benefits, which pay benefits if the insured lets the policy lapse. Common nonforfeiture benefits are a return of premiums or a shortened benefit period. Under the return-of-premium option, the insured receives cash after the policy lapses, which is a percentage of the total premiums paid. Under a shortened benefit period, coverage continues, but the benefit period or maximum dollar amount is reduced.

Advantages and Disadvantages of Long-Term Care Insurance Long-term care insurance can reduce or eliminate the crushing financial burden of an extended stay in a skilled nursing facility or assisted living facility, or specialized care in the home. However, private long-term care policies have two major disadvantages. First, long-term care coverage is expensive. Depending on the daily benefit amount and the applicant’s age and state, annual premiums for older insureds can cost $3,000, $4,000, or some higher amount. The majority of elderly with limited incomes cannot pay these high premiums and are thus uninsured for long-term care. Second, the elderly face considerable financial risks over time if premiums are increased. Most long-term care policies are guaranteed renewable, which allows insurers to increase premiums for broad classes of insureds. In many policies, the insured also has the right to increase the daily benefit amount each year based on the increase in the CPI. However, annual premiums will also increase if the insured increases the daily benefit amount. As a result, many older policyholders may be faced with premium increases over time that make it difficult to keep their policies.

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Group Health Insurance Coverages Group health insurance plans are extremely important in providing economic security to employees and their families. Group plans currently account for more than 90 percent of the total premiums paid for medical expense insurance in the individual and group markets. This section discusses the major types of group coverages available today.7 Group medical expense coverage is available from a number of sources, including the following: • Commercial insurers • Blue Cross and Blue Shield plans • Managed care organizations • Self-insured employer plans

Commercial Insurers Commercial life and health insurers sell both individual and group medical expense plans. Some property and casualty insurers also issue various types of health insurance. Most individuals and families insured by commercial insurers are covered under group plans. The business is highly concentrated. As stated in Chapter 8, one to three insurers dominate the local health insurance markets in the majority of metropolitan areas. Commercial insurers also sponsor managed care plans that provide benefits to members in a cost-effective manner, including health maintenance organizations (HMOs) and preferred provider organizations (PPOs). Managed care plans are discussed in greater detail later in the chapter.

Blue Cross and Blue Shield Plans Blue Cross and Blue Shield plans are medical expense plans that cover hospital expenses, physician and surgeon fees, ancillary charges, and other medical expenses. Major medical insurance is also available. The various plans sell individual, family, and group coverage. Most insureds are covered by group plans. Blue Cross plans cover hospitalization and related expenses. The plans typically provide service benefits rather than cash benefits to the insured, and payment is made directly to the hospital rather than to the insured. Blue Shield plans cover physicians’ and surgeons’ fees and related medical expenses. Most plans today include both Blue Cross and Blue Shield coverage. The joint plans offer both basic medical expense benefits and major medical insurance. Finally, like commercial insurers, Blue Cross and Blue Shield plans also sponsor managed care plans, including HMOs and PPOs. In the majority of states, Blue Cross and Blue Shield plans are nonprofit organizations that receive favorable tax treatment and are regulated under special legislation. However, in order to raise capital and become more competitive, several Blue Cross

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and Blue Shield plans have converted to a for-profit status, with stockholders and a board of directors. In addition, many nonprofit plans own for-profit affiliates.

Managed Care Organizations Managed care organizations are another source of group medical expense benefits. These organizations generally are for-profit organizations that offer managed care plans to employers. As stated earlier, managed care is a generic term for medical expense benefits that are provided to covered employees in a cost-effective manner. There is great emphasis on controlling costs, and the medical care provided by physicians is carefully monitored. Managed care is discussed in greater detail later in the chapter.

Self-Insured Plans by Employers Many employers, primarily larger employers, self-insure part or all of the benefits provided to their employees. Self-insurance (also called self-funding) means that the employer pays part or all of the cost of providing health insurance to the ­employees. Self-insured plans are usually established with stop-loss insurance and an administrative-services-only (ASO) contract. Stop-loss insurance means that a commercial insurer will pay claims that exceed a certain dollar amount up to some maximum limit. An ASO contract is a contract between an employer and commercial insurer (or other third party) in which the insurer provides only administrative services. These services can include plan design, claims processing, actuarial support, and record keeping. Employers self-insure their medical expense plans for several reasons, including the following: • Under the Employee Retirement Income Security Act of 1974 (ERISA), selfinsured plans generally are not subject to state regulation. Thus, a national employer does not have to comply with laws in 51 jurisdictions. • Costs may be reduced or increased less rapidly because of savings in state premium taxes, commissions, and the insurer’s profit. • The employer retains part or all of the funds needed to pay claims and earns interest until the claims are paid. • Self-insured plans are exempt from state laws that require insured plans to offer certain state-mandated benefits.

Traditional Indemnity Plans Group medical expense plans have changed dramatically over time. Older plans were called indemnity plans or fee-for-service plans. Physicians were paid a fee for each covered service; the insured had considerable freedom in selecting physicians and other health-care providers; the plans paid cash indemnity benefits for covered services up to certain limits; and cost containment was not heavily stressed. Tradi-

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tional indemnity plans have declined in importance and cover less than l percent of all covered employees at the present time.

Managed Care Plans Traditional group indemnity plans have declined in importance because of the rapid growth in managed care plans. As stated earlier, managed care is a generic name for medical expense plans that provide covered services to the members in a cost-effective manner. Under such plans, the employee’s choice of physicians and hospitals may be limited to certain health-care providers; cost control and reduction are heavily emphasized; utilization review is done at all levels; the quality of the care provided by physicians is carefully monitored and evaluated; health-care providers share in the financial results through various risk-sharing techniques; and preventive care and healthy lifestyles are emphasized. There are several types of managed care plans. The most important include the following: • Health maintenance organizations (HMOs) • Preferred provider organizations (PPOs) • Point-of-service (POS) plans

Health Maintenance Organizations (HMOs) A health maintenance organization (HMO) is an organized system of health care that provides comprehensive services to its members. HMOs have a number of basic characteristics: • Organized health-care plan. HMOs have the responsibility for organizing and delivering comprehensive health services to their members. The HMO owns or leases medical facilities, enters into agreements with hospitals and physicians to provide medical services, hires ancillary personnel, and has general managerial control over the various services provided. • Broad, comprehensive medical services. HMOs provide broad, comprehensive health services to their members. Covered services typically include hospital care, surgeons’ and physicians’ fees, maternity care, laboratory and X-ray services, outpatient services, special-duty nursing, and numerous other services. Office visits to HMO physicians are also covered, either in full or at a nominal charge for each visit. • Restrictions on the choice of health-care providers. Traditional HMOs typically limit the choice of physicians and other health-care providers who are part of the HMO network. However, some HMOs allow the people they insure to select physicians outside the plan network at higher out-of-pocket costs. In addition, because HMOs operate in a limited geographical area, there may be limited coverage for treatment received outside of the area. HMOs typically only provide emergency medical treatment outside of the geographical area of the HMO.

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• Payment of fixed premiums and cost-sharing provisions. HMO members typically pay a fixed prepaid fee (usually paid monthly) for the medical services provided. Many HMOs now have cost-sharing provisions. In previous years, HMOs did not emphasize deductibles or coinsurance to any great extent. However, in recent years, employers have been faced with sizable premium increases. To hold down costs, many HMOs now require members to meet an annual deductible. Some HMOs also impose an inpatient deductible for a hospital stay. In addition, many HMOs require members to meet a coinsurance requirement for covered services. Employees must also pay copayments for certain services, such as $30 for an office visit or $10 for a generic drug. • Heavy emphasis on controlling cost. HMOs place heavy emphasis on controlling costs. HMOs typically pay physicians or medical groups a capitation fee, which is a fixed annual amount for each plan member regardless of the number of services provided. Some HMO physicians are paid a salary, which holds down costs because the provider has no financial incentive to provide unnecessary services. HMOs also enter into contracts with specialists and providers to provide certain services at negotiated fees. Finally, HMOs emphasize preventive care and healthy lifestyles, which also hold down costs. Types of HMOs

There are several types of HMOs. They include the following: • Staff model. Under a staff model, physicians are employees of the HMO and are paid a salary and possibly an incentive bonus to hold down costs. • Group model. Under a group model, physicians are employees of another group that has a contract with the HMO to provide medical services to its members. The HMO pays the group of physicians a monthly or annual capitation fee for each member. As stated earlier, a capitation fee is a fixed amount for each member regardless of the number of services provided. In return, the group agrees to provide all covered services to members during the year. The group model typically has a closed panel of physicians that requires members to select physicians affiliated with the HMO. • Network model. Under a network model, the HMO contracts with two or more independent group practices to provide medical services to covered members. The HMO pays a fixed monthly fee for each member to the medical group. • Individual practice association plan. A final type of HMO is an individual practice association (IPA) plan. An IPA is an open panel of physicians who work out of their own offices and treat patients on a fee-for-service basis. However, the individual physicians agree to treat HMO members at reduced fees, either a capitation fee for each member or a reduced fee for each HMO patient treated. In addition, to encourage cost containment, IPAs may have risk-sharing agreements with the participating physicians. Payments may be reduced if the plan experience is poor. A bonus is paid if the plan experience is better than expected.

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Preferred Provider Organizations (PPOs) A preferred provider organization (PPO) is a plan that contracts with health-care providers to provide certain medical services to the plan members at discounted fees. To encourage patients to use PPO providers, deductibles and coinsurance charges are reduced. In addition, the patient may be charged a lower fee for certain routine treatments, or offered increased benefits, such as preventive health-care services. PPOs should not be confused with HMOs. There are important differences. First, PPO providers typically do not provide medical care on a prepaid basis, but are paid on a fee-for-service basis as their services are used. However, as stated earlier, the fees charged are below the provider’s regular fee. Second, unlike an HMO, patients are not required to use a preferred provider but have freedom of choice every time they need care. However, the patients have a financial incentive to use a preferred provider because the deductible and coinsurance charges are reduced. In addition, if the health-care provider’s actual charge exceeds the negotiated fee, the provider absorbs the excess amount. In such cases, savings to the patient are substantial. For example, assume that a surgeon who participates in a PPO charges a regular fee of $5,000 for a knee operation. If the negotiated fee is $2,500, the patient does not pay the additional $2,500. The participating surgeon absorbs this amount. Finally, PPOs typically do not use a gatekeeper physician, and employees do not have to get permission from a primary care physician to see a specialist. A gatekeeper physician is a primary care physician who must give permission or approval to his or her patients to see a specialist. To control costs, many HMOs require members to get permission from the primary care physician to see a specialist. In contrast, patients in a PPO can visit a specialist directly without first getting approval from the primary care physician. PPOs have the major advantage of controlling health-care costs because provider fees are negotiated at a discount. PPOs also help physicians to build up their practice. Patients also benefit because they pay substantially less for their medical care.

Point-of-Service (POS) Plans A point-of-service plan is typically structured as an HMO, but plan members are allowed to go outside the network for medical care. The POS plan establishes a network of preferred providers. If patients see providers who are in the network, they pay little or nothing out of pocket, which is similar to an HMO. However, if patients receive care from providers outside the network, the care is covered, but the patients must pay substantially higher deductibles and coinsurance charges. The POS plan has the major advantage of preserving freedom of choice for plan members; it also eliminates the fear that plan members will not be able to see a physician or specialist of their choice. The major disadvantage is the substantially higher cost that a member must pay to see a provider outside of the network.

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Advantages of Managed Care Plans Managed care plans have a number of advantages. They generally have lower hospital and surgical utilization rates than traditional group indemnity plans; plan members pay reduced out-of-pocket expenses if they utilize network providers; and employees do not have to file claim forms. Finally, managed care plans promote wellness programs and healthy lifestyles for employees, which tend to hold down costs.

Disadvantages of Managed Care Plans Managed care plans also have certain actual or perceived disadvantages. Critics claim that the quality of care under these plans is being reduced because of the heavy emphasis on cost control. It is argued that some gatekeeper physicians do not refer sick patients promptly to specialists; for-profit HMOs may skimp on preventive care to maximize profits; many physicians criticize managed care plans because of the restrictions placed on their freedom to treat patients, including arguments with insurers for additional days of hospital coverage for patients who are too sick to be released, and disputes with insurers over denied claims or treatment procedures. In addition, managed care plans may provide financial incentives to health-care providers to hold down costs, which can lead to a conflict of interest between physicians’ obligation to provide high-quality medical care to patients and the incentive to hold down costs in order to increase the amount of their bonus. Although many physicians and patients are dissatisfied with managed care plans, studies show that the quality of care is improving. The National Committee for Quality Assurance (NCQA), a major accreditation organization, conducts an annual survey of health plans and rates the plans based on the quality of services provided. NCQA concluded that the quality of health care for millions of Americans improved in 2007. However, the NCQA also concludes that variations in evidence-based care cause many people to receive substandard care. As stated in Chapter 8, the quality of care varies widely depending on geographic location. Commercial health plans in Maine, New Hampshire, Vermont, Massachusetts, Connecticut, and Rhode Island received quality scores that were substantially above the national average. In contrast, plans in Texas, Oklahoma, Arkansas, Louisiana, Mississippi, Alabama, Tennessee, and Kentucky had quality scores that were substantially below the national average. NCQA concludes that eliminating variations in the delivery of evidence-based care could save up to 88,000 lives each year.8

Consumer-Directed Health Plans Because of rapidly rising premiums, many employers have adopted consumer-directed health plans. A consumer-directed health plan is a generic term for a plan that gives employees a choice of several health-care plans that are designed to make employees more sensitive to health-care costs, to provide a financial incentive to avoid unnecessary care, and encourage them to seek out low-cost providers. There are a number of

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consumer-directed plans. Two plans merit a brief discussion: (1) defined-contribution health plans, and (2) high-deductible health plans.

Defined-Contribution Health Plans Under a defined-contribution health plan, employees have a choice of several plans, such as an HMO, PPO, or POS, to which the employer contributes a fixed amount— hence the term “defined contribution.” For example, assume that the employer contributes a maximum of $300 monthly to any group plan selected by an employee. If the plan requires a premium of $500 monthly premium, the employee must pay a monthly premium of $200. Thus, if the employee selects a more expensive plan, he or she will incur greater out-of-pocket costs. Since the employer pays a fixed amount, the employee has a financial incentive to sign up for a less costly plan.

High-Deductible Health Plans A high-deductible plan is one that combines a high-deductible major medical health insurance plan with a health reimbursement account (HRA) or a health savings account (HSA). An HRA is an employer-funded plan with favorable tax advantages through which the employee is reimbursed for medical expenses that are not covered by the employee’s plan, such as deductibles, coinsurance, copayments, and other noncovered medical services. Although high-deductible health plans enable employers to control health-care costs, critics argue that these plans encourage employers to shift rising premium costs to the employees in the form of increased deductibles and higher annual out-of-pocket expenses. In addition, critics argue that because of high deductibles and other costsharing provisions, some employees may postpone needed medical treatment or the purchase of life-enhancing prescription drugs.

Continuation of Health Insurance for Terminated Employees Workers frequently lose their group health insurance coverage because they quit their jobs or are fired or laid off. This is particularly true for millions of workers who were laid off during the severe 2008 and 2009 financial meltdown and business downswing. The Consolidated Omnibus Budget Reconciliation Act (COBRA), enacted in 1985, requires employers to offer group health insurance benefits to terminated employees, their spouses, and dependent children. COBRA applies to employers and to state and local government agencies that employ 20 or more workers on a typical business day during the preceding calendar year. Under this law, terminated employees have the option of continuing their group health insurance protection for up to 18 months if they are voluntarily or involuntarily terminated from their jobs or have their hours reduced. In certain cases, COBRA coverage could last up to 36 months. The employee’s spouse and dependents can

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continue to be covered for up to three years if the employee dies, is legally separated or divorced, becomes eligible for Medicare protection, or has a dependent child who reaches the maximum age for coverage. COBRA coverage is expensive. Terminated employees who elect to exercise their COBRA rights must pay 102 percent of the group premium, which can easily exceed $1,200 monthly for a family policy. To assist the millions of workers who lost their jobs and health insurance during the severe 2008–2009 downturn, the American Recovery and Reinvestment Act of 2009 (also called the stimulus program) provided a temporary 65 percent premium subsidy to eligible individuals who were involuntarily terminated from their jobs through the end of May 2010. Due to the statutory sunset in the law, the COBRA premium reduction is not available for individuals who were involuntarily terminated after May 31, 2010.

Recent Developments in Group Medical Expense Plans Most of the recent developments in employer-sponsored medical expense plans focus on holding down rising health-care costs to employers. These developments include the following: • Continued escalation in health insurance premiums. Group health insurance premiums continue to rise. In 2010, average annual premiums for employersponsored health plans reached $5,049 for single coverage and $13,770 for family coverage. The share of premiums paid by employees has increased much more rapidly than wages and inflation in recent years. As a result, the real incomes of workers have been eroded by rising premiums. Since 2005, the workers’ contributions to premiums increased 47 percent, while overall premiums rose 27 percent, but wages increased only 18 percent, and inflation rose only 12 percent.9 • Higher deductibles for employees. In response to rising costs, employers continue to shift costs to their employees by higher cost-sharing provisions. In addition to higher premiums, a growing number of employees face significantly higher annual deductibles in their employers’ plans. In 2010, the average annual deductible for single coverage was $675 for workers in PPOs, $601 for workers in HMOs, $1,048 for workers in POS plans, and $1,903 for workers in high-deductible health plans with a savings option.10 About one in four covered workers now face annual deductibles of $1,000 or more, including nearly half of the workers employed by small business firms.11 • Dominance of PPOs. Preferred provider organizations continue to dominate group health insurance markets. The majority of covered workers (58 percent) are enrolled in PPOs; health maintenance organizations cover 19 percent; pointof-service plans cover 10 percent; high-deductible health plans with a savings option cover 13 percent; and conventional plans cover only 1 percent.12 • Tiered pricing for prescription drugs. To hold down increases in prescription drug costs, employers have adopted a tiered pricing system. The vast majority of employees now face a three-tier or four-tier pricing system for prescription

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drugs. Copayment charges vary depending on the drug used. In 2010, the average copayment for first-tier drugs, (generic drugs), was $11. For second-tier drugs (preferred drugs on an approved list), the average copayment was $28; for third-tier drugs, such as drugs not on the approved list, the average copayment was $49; and for fourth-tier drugs, $89.13 Fourth-tier drugs generally are costly biological agents and lifestyle drugs. • Wellness benefits. Many employers have designed voluntary wellness programs for their employees. These include weight-loss programs, gym membership discounts, onsite exercise facilities, smoking cessation programs, nutrition programs, newsletters, Web sites that encourage healthy living, and similar programs. Many large employers provide financial incentives to their employees to encourage them to participate in health management or wellness programs. These employers believe that the encouragement of better health habits will result in lower spending on health care and a more productive workforce. • Health risk assessments. Large employers increasingly are using health risk assessments to learn about their employees’ health habits. A health risk assessment is an evaluation of the employee’s health status based on information provided by the employee, such as health history and current medical condition. The evaluation identifies employees who might benefit from disease management programs, such as counseling and preventive services for asthma, diabetes, heart disease, and other diseases. • Onsite health clinics. Many large employers (1,000 employees or more) have onsite health clinics for employees at one or more locations. Employees can receive treatment for nonoccupational diseases or injury at these locations. Employers with onsite facilities believe it is less expensive to provide onsite coverage for routine medical expenses rather than through traditional healthcare channels.

Group Disability Income Insurance In addition to medical-expense plans, large employers typically have one or more disability income plans for their employees. Group disability income insurance pays weekly or monthly cash payments to employees who are disabled from sickness or injury. There are two basic types of group disability plans: short-term plans and long-term plans.

Short–Term Disability Income Plans Many employers provide short-term disability income benefits to their employees. The benefits are paid for relatively short periods, ranging from 13 weeks to 2 years. The majority of short-term plans pay benefits for a maximum of 26 weeks. In addition, most plans have a short elimination period of one to seven days for sickness to discourage malingering and excessive absenteeism, while accidents are usually covered from the first day of disability. Most short-term plans cover only nonoccupational disability, which means that the

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sickness or injury must occur off the job. Job-related disabilities are covered under workers’ compensation. Disability is typically defined in terms of the worker’s own occupation. A worker is considered totally disabled if unable to perform each and every duty of the his or her regular occupation. Partial disability is seldom covered under a short-term plan. The worker must be totally disabled to qualify for benefits. The amount of the weekly or monthly benefit is related to the worker’s normal earnings and is typically equal to some percentage of weekly earnings, such as 50 to 70 percent.

Long-Term Disability Income Plans Many employers also provide long-term disability income benefits. These plans pay benefits for longer periods. Long-term plans typically pay benefits up to age 65 or 70 as long as the worker remains disabled. However, some plans have maximum benefit periods that are shorter, such as up to two years. A dual definition of total disability is typically used in long-term plans. For the first two years, disability is defined as the inability of the insured to perform all duties of his or her occupation. After that time, the worker is considered disabled if he or she is unable to work in any occupation reasonably fitted by training, education, and experience. Also, in contrast to short-term plans, long-term plans usually cover both occupational and nonoccupational disability. The maximum monthly benefits are usually limited to 50 to 70 percent of the employee’s normal earnings. Since long-term plans are designed largely for average and upper-income employees, monthly benefits of $4,000, $5,000, or even higher are commonly paid. Most plans have a waiting period of three to six months before benefits are paid. To hold down costs and to reduce malingering and moral hazard, Social Security and workers’ compensation benefits are taken into consideration, and the long-term benefit is reduced accordingly. Finally, many plans provide for a limited annual cost-of-living adjustment and a pension accrual benefit, which provides for a pension contribution so that the disabled person’s normal pension benefit remains intact.

Sick Leave Plans Many firms have formal sick leave plans that pay the employee’s full salary during an initial period of disability. A common approach is to give workers one day of sick leave for each month worked. However, sick leave may not be given to new employees until they have been with the company for a certain period, such as three or six months. Sick leave plans have two major limitations. First, they are designed largely for short-term disabilities and generally are not used to pay a disabled person’s wages during a long-term disability. Second, sick leave plans are vulnerable to abuse by some employees, who tend to use sick leave days because they are available. It is not uncommon for workers to fake an illness each month and take one or two days off at the employer’s expense.

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Summary • The Patient Protection and Affordable Care Act has important provisions that have a significant impact on individual and group medical expense plans. The new law is compulsory for most people beginning in 2014; lifetime limits are prohibited; exclusions for pre-existing conditions for children are prohibited for children under age 19 and for adults in 2014; and young adults can remain on their parents’ policy until age 26. In addition, rescission of individual contracts is not allowed; variations in rating are allowed only for age, geographical area, tobacco use, and number of family members; applicants will have a choice of four plans plus a separate catastrophic plan for those under age 30 and those who are exempt from the mandate to buy coverage; there is no cost sharing for preventive services; and insurers must have a minimum loss ratio of 85 percent for large group plans and 80 percent for individual and small group plans. Finally, premium credits will be available to eligible individuals and families; tax credits are now available to small employers; and employers with 50 or more employees that do not offer coverage to their employees, and for whom at least one employee receives a premium tax credit through a Health Insurance Exchange, will be assessed an annual fee of $2,000 for each full-time employee (in excess of 30 employees). • A typical individual major medical policy has the following characteristics: payment of catastrophe benefits, broad range of benefits, calendar-year deductible, coinsurance requirements, annual out-of-pocket limits, and certain exclusions. • A health savings account (HSA) is a high-deductible major medical policy that receives favorable tax treatment. Contributions go into an investment account and are income-tax deductible; the investment income builds up income-tax free; and withdrawals are income-tax free when used to pay for qualified medical expenses. In addition, premiums are waived if the insured is totally disabled for at least 90 days. • Disability income policies provide for the periodic payment of income to an individual who is totally disabled. The benefits are paid after an elimination period is satisfied. The insured typically has a choice of benefit periods for accidents and sickness. • Disability can be defined as (1) the inability to perform all duties of the insured person’s own occupation; (2) the inability to perform the duties of any occupation for which the insured is reasonably fitted by training, education, and experience; (3) the inability to perform the duties of any gainful occupation, which may be found in policies that insure hazardous occupations; and (4) qualification under a loss-of-income test, which considers the actual loss of earned income as an objective measure of disability. Many policies combine the first two definitions. • Residual disability means that a pro rata disability benefit is paid to an insured person whose earned income is reduced because of an accident or illness. • Long-term care insurance pays a daily benefit for medical or custodial care in a nursing facility. The insured individual must meet one of two benefit triggers to receive benefits. The first trigger requires the insured to be unable to perform a

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certain number of activities of daily living (ADLs), which typically are eating, bathing, dressing, transferring from a bed to a chair, using the toilet, and being continent. The second trigger is the presence of a severe cognitive impairment and a resultant need for supervision. • Group medical expense coverages are available from commercial insurers, Blue Cross and Blue Shield plans, managed care organizations, and self-insured employer plans. • Managed care is a generic term for a medical expense plan that provides necessary medical care in a cost-effective manner. There is heavy emphasis on controlling costs. • A health maintenance organization (HMO) is an organized system of health care that provides comprehensive services to its members. HMOs have the responsibility for organizing and delivering comprehensive health services to members; the plans provide broad, comprehensive health services to the members; traditional HMOs typically limit the choice of physicians and other health-care providers who are part of the HMO network, but some HMOs allows members to go outside the network with the payment of higher deductibles and coinsurance payments; members pay fixed premiums for their coverage, but many HMOs also have costsharing provisions; finally, HMOs place heavy emphasis on controlling costs. • A preferred provider organization (PPO) is a plan that contracts with health-care providers to provide certain medical services to the plan members at discounted fees. To encourage patients to use PPO providers, deductibles and coinsurance charges are reduced. • A point-of-service (POS) plan is a managed care plan that allows members to receive care outside the network of preferred providers. However, the patient must pay substantially high deductible and coinsurance charges. • A consumer-directed health plan is a generic term for a plan that gives employees a choice of several health-care plans that are designed to make them more sensitive to health-care costs, to provide a financial incentive to avoid unnecessary care, and encourage them to seek out low-cost providers. • There are a number of consumer-directed plans. Under a defined-contribution plan, employees have a choice of several plans, such as an HMO, PPO, or POS, to which the employer contributes a fixed amount. A high-deductible plan is a plan that combines a high-deductible major medical health insurance plan with a health reimbursement account (HRA) or with a health savings account (HSA). An HRA is an employer-funded plan with favorable tax advantages that reimburse the employee for medical expenses that are not covered by the employee’s plan, such as deductibles, coinsurance, copayments, and other medical services not covered by the plan. • Current developments in group medical expense plans include continued escalation in health insurance premiums; higher deductibles for employees; dominance of group market by preferred provider organizations (PPOs); tiered pricing for prescription drugs; availability of wellness benefits; health risk assessments; and onsite health clinics.

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• Many employers provide short-term disability income benefits to their employees. Short-term plans generally cover only sickness or accidents that are not job-related. The benefits are paid for relatively short periods, ranging from 13 weeks to 2 years. The majority of short-term plans pay benefits for a maximum of 26 weeks. Most plans have a short elimination period of one to seven days for sickness to discourage malingering and excessive absenteeism, while accidents are usually covered from the first day of disability. • Many employers also provide long-term disability income benefits. Long-term plans typically pay benefits up to age 65 or 70 as long as the worker remains disabled. However, some plans have maximum benefit periods that are shorter, such as two years. • A dual definition of total disability is typically used in long-term plans. For the first two years, disability is defined as the inability of the insured to perform all duties of his or her occupation. After that time, the worker is considered disabled if he or she is unable to work in any occupation reasonably fitted by training, education, and experience. Long-term plans usually cover both occupational and nonoccupational disability.

Review Questions 1. List the major changes to individual and group medical expense insurance coverages under the Patient Protection and Affordable Care Act. 2. Describe the basic characteristics of major medical insurance. 3. What is a health savings account? Explain your answer. 4. Describe the basic characteristics of long-term care insurance. 5. Explain the basic characteristics of individual disability income insurance. 6. Briefly explain the different definitions of disability in individual disability income insurance. 7. Describe the basic characteristics of the following managed care plans: a. Health maintenance organization (HMO) b. Preferred provider organization (PPO) c. Point of service plan (POS) 8. Describe the basic characteristics of the following consumer-directed plans: a. Defined-contribution plans b. High-deductible plans 9. Briefly explain how terminated employees can keep their group health insurance under the COBRA law. 10. Briefly describe the current developments in group health insurance.

Application Questions 1. Megan, age 28, is insured under an individual major medical policy. The plan has a calendar-year deductible of $1,500, a 25 percent coinsurance provision, and an annual out-of-pocket limit of $4,000. Megan recently had arthroscopic

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surgery on her knee, which she injured while playing softball. The surgery was performed in an outpatient surgical center. Megan incurred the following charges: – Outpatient X-rays and diagnostic tests: $800 – Covered charges in the surgical center: $10,000 – Surgeon’s fee: $3,000 – Outpatient prescription drugs (generic): $200 – Physical therapy: $1,500 In addition, Megan could not work for two weeks and lost $2,000 in earned income. a. Based on the above information, how much of the loss will be paid by the insurance company? Explain your answer. b. Why is coinsurance used in a major medical policy? c. Identify several exclusions in a typical major medical policy. 2. James currently earns $3,000 per month. He has an individual disability income policy that will pay $1,800 monthly if he is totally disabled. The policy has a 60-day elimination period and also provides residual disability benefits. Benefits are payable to age 65. a. Assume that James is severely injured in an auto accident and cannot work for four months; how much will he collect under his policy? b. Assume that James returns to work at the beginning of the third month of disability but can only work part-time until he recovers completely. His part-time earnings are $1,500. What is the amount, if any, that James can collect under his policy? Explain your answer. 3. Many employers have both group short-term and long-term disability-income plans. Compare (1) short-term plans with (2) long-term plans with respect to each of the following: a. Definition of disability under the plan b. Elimination period c. Length of the benefit period

Internet Resources • America’s Health Insurance Plans (AHIP) is a national association that represents nearly 1,300 member companies providing health-care benefits to more than 200 million Americans. AHIP’s principal purpose is to represent the interests of its members on legislative and regulatory issues at the federal and state levels, and with the media, consumers, and employers. AHIP provides information and services, such as newsletters, publications, a magazine, and online services, and conducts education, research, and quality assurance programs. Visit the site at www.ahip.org • Families USA works to promote high-quality affordable health care for all Americans. The site provides timely information on the new health-care reform law and the problems Americans face in paying for medical bills. Visit the site at www.familiesusa.org

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• HealthCare.gov is the official Web site of the federal government that provides detailed information on the new health-care reform law and its implementation. Click on “Understanding the New Law” for a convenient source of information concerning the provisions of the new law. Visit the site at www.healthcare.gov • The Henry J. Kaiser Family Foundation is one of the best sources of information concerning the new health-care reform law and related topics on health insurance. Visit the site at www.kff.org • HealthGrades is the leading health-care ratings organization that provides ratings and profiles of hospitals, nursing homes, and physicians to consumers, corporations, health plans, and hospitals. Visit the site at www.healthgrades.com • iHealthBeat is published daily by the California HealthCare Foundation, which provides the latest news on the impact of new technology on health care. The site also provides information on health-care reform and health insurance. Visit the site at www.ihealthbeat.org

Selected References AHIP Center for Policy and Research. “Individual Health Insurance 2009: A Comprehensive Survey of Premiums, Availability and Benefits.” Washington, DC, October 2009. Beam, Burton T., Jr. Group Benefits: Basic Concepts and Alternatives. 12th ed. Bryn Mawr, PA: The American College Press, 2010. Families USA. “Lives on the Line: The Deadly Consequences of Delaying Health Reform.” Washington, DC, February 2010. ———. “New Report Finds 86.7 Americans Were Uninsured at Some Point in 2007–2008.” Press release, March 4, 2009. HealthCare.gov. “Provisions of the Affordable Care Act, by Year, 2010.” Available at www.healthcare .gov Henry J. Kaiser Family Foundation. “Employer Health Benefits: 2010 Summary of Findings.” Menlo Park, CA, 2010. ———. Summary of New Health Care Reform Law. Menlo Park, CA, June 18, 2010. Mercer. “Health Care Reform: Impact on Employer-Sponsored Plans Begins to Emerge.” Health & Benefits Perspective, June 2010. New York Times. “Editorial: End to Rescission, and More Good News.” May 2, 2010. Available at www.nytimes.com NPR/Kaiser Foundation/Harvard School of Public Health. “The Public and the Health Care Delivery System.” April 2009. Available at www.kff.org/kaiserpolls/upload/7887.pdf Rejda, George E. Principles of Risk Management and Insurance. 11th ed. Boston: Pearson Education, 2011. Chapters 15, 16. U.S. Department of Health and Human Services. “HHS Secretary Sebelius Announces New Pre-Existing Condition Insurance Plan.” News release, July 1, 2010.

Notes 1. This section is based on George E. Rejda, Principles of Risk Management and Insurance. 11th ed. (Boston: Pearson Education, 2011), pp. 316–327. 2. AHIP Center for Policy and Research, “Individual Health Insurance 2009: A Comprehensive Survey of Premiums, Availability and Benefits.” Washington, DC, October 2009, p. 26.

Notes  221 3. Social Security Administration, Disability Benefits. SSA Publication no. 5 05–10029, August 2010, ICN 456000. 4. Thomas P. O’Hare and Burton T. Beam, Jr., Individual Health Insurance Planning: Medical, Disability Income, and Long-Term Care (Bryn Mawr, PA: The American College, 2008), p. 12.3. Data are from the Society of Actuaries, Commissioner’s Individual Disability Table A. 5. Medicare.gov, Long-term Care. Available at www.medicare.gov/LongTermCare/Static/Home.asp 6. This section is based on O’Hare and Beam, Jr., Individual Health Insurance Planning, Ch. 19. 7. This section is based on Rejda, Principles of Risk Management and Insurance, pp. 342–352. Used with permission of Pearson Education, Inc., Upper Saddle River, NJ. 8. NCQA, “Report: Health Care Quality Improves But Varies Across Different Regions of the Country.” News release, October 2, 2008. Washington, DC. 9. The Henry J. Kaiser Family Foundation, “Family Health Premiums Rise About 3 Percent to $13,770 in 2010, But Workers’ Share Jumps 14 Percent as Firms Shift Cost Burden.” News release, September 2, 2010. 10. Henry J. Kaiser Family Foundation, Employer Health Benefits: 2010 Summary of Findings. Menlo Park, CA, 2010. 11. Ibid. 12. Ibid. 13. Ibid.

10 Health-Care Reform and the Medicare Program

Student Learning Objectives After studying this chapter, you should be able to: • Identify the groups who are covered under Hospital Insurance (Part A) of the Medicare program. • Describe the benefits under the Original Medicare Plan. • Explain how Medicare Advantage Plans differ from the Original Medicare Plan. • List the various options available to beneficiaries under Medicare Advantage Plans. • Explain the prescription drug coverage under Medicare. • Explain how the Medicare program is financed. • Explain the financing problems that Medicare is currently experiencing. • Describe the major changes to the Medicare program under the Affordable Care Act. People age 65 and older see physicians more often, are more likely to become disabled, and have longer hospital stays. Because the majority of aged retired people were uninsured for health care, the 1965 amendments to the Social Security Act established a compulsory hospital insurance plan for the aged and a related voluntary medical insurance plan. Medicare is an important part of the total Social Security program that covers the medical expenses of most persons age 65 and older. Medicare also covers disabled persons under age 65 who have been entitled to disability benefits for 24 months. In addition, Medicare covers persons younger than age 65 who need long-term kidney dialysis treatment or a kidney transplant. In this chapter, we discuss the basic provisions of the Medicare program, current financial problems and issues, and the impact of the new health-care reform law on the Medicare program. 222

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Overview of Medicare The Medicare program is complex and controversial. Since its inception in 1965, Medicare has been changed numerous times. Medicare currently has a bewildering array of plans, including prescription drug plans and health-care plans of private insurers. The current Medicare program includes the following:1 • The Original Medicare Plan • Medicare Advantage Plans • Other Medicare health plans • Medicare Prescription Drug Plans

The Original Medicare Plan Beneficiaries can elect the Original Medicare Plan, which is the traditional plan run by the federal government that provides Part A and Part B benefits. Beneficiaries can elect any provider that accepts Medicare patients. Medicare pays its share of the bill, and the beneficiary pays the balance. Some services are not covered.

Hospital Insurance (Part A) Hospital Insurance (Part A) provides inpatient hospital care and related post-hospital care for most people age 65 and older. Major benefits include the following: • Inpatient hospital care. Inpatient hospital care is provided for up to 90 days for each benefit period. Inpatient care does not include custodial or long-term care. A benefit period begins when the patient first enters the hospital and ends when he or she has been out of both the hospital and a skilled nursing facility for 60 consecutive days. For the first 60 days, Medicare pays all covered costs except an initial inpatient hospital deductible ($1,132 in 2011). The deductible is paid only once during the benefit period no matter how many times the patient is hospitalized. For the 61st through 90th day, Medicare pays all covered costs except for a daily coinsurance charge ($283 in 2011). If the patient is still hospitalized after 90 days, a lifetime reserve of 60 additional days can be used. Lifetime reserve days are subject to a daily coinsurance charge ($566 in 2011). The inpatient hospital deductible and coinsurance charges are adjusted annually to reflect changes in hospital costs. Covered hospital services include a semiprivate room, meals, general nursing, inpatient drugs, operating and recovery room costs, and other hospital services and supplies. A private room is not covered unless medically necessary. Neither television nor phone is covered if there is a separate charge for these items, and personal care items like razors or slipper socks are not covered. • Skilled nursing facility care. Inpatient care in a skilled nursing facility is also covered. A skilled nursing facility is a facility that provides skilled nursing care and rehabilitation services on a continuous, daily basis. Skilled nursing facility care includes physical therapy or intravenous injections that can only be given by a registered

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nurse or doctor. In addition, many nursing homes in the United States are not skilled nursing facilities and provide only custodial care, such as assistance with eating, bathing, and taking the right medication. Medicare does not cover custodial care. The patient must be hospitalized for at least three days to be eligible for coverage in a skilled nursing facility, and confinement must be for medical reasons. A maximum of 100 days of coverage is provided per benefit period. The first 20 days are paid in full. For the next 80 days, the patient must pay a daily coinsurance charge ($141.50 in 2011). No benefits are available after 100 days of care in a benefit period. • Blood. If a hospital obtains blood from a blood bank at no charge, the patient does not have to pay for the blood or replace it. However, if the hospital buys blood for the patient, he or she must pay the hospital costs for the first three units of blood received in a calendar year, or the blood must be donated by the patient or another person. • Home health care. Hospital Insurance also covers home health-care visits by visiting nurses, physical therapists, speech therapists, and other health professionals. Home health-care visits are covered only under the following conditions: (1) the patient requires part-time or intermittent skilled nursing care, physical therapy, or speech language pathology, or has a continuing need for occupational therapy; (2) a physician or other health-care provider must order the patient’s care, and a Medicarecertified home health agency must provide it; and (3) the patient must be homebound, which means that leaving the home is a major effort. There are no cost-sharing provisions that apply to covered home health-care services, but the patient must pay 20 percent of the Medicare-approved amount for durable medical equipment, such as a walker. • Hospice care. Hospice care is available for patients with a terminal illness. A physician must certify that the patient is expected to live six months or less. Coverage includes drugs to relieve pain and manage symptoms; medical, nursing, and social services; and other covered services, such as grief counseling for family members. Medicare-approved hospice usually provides hospice care in the patient’s home or another facility, such as a nursing home. Hospice care does not include charges for room and board unless the hospice medical team determines that the patient needs short-term impatient stays for pain control and symptom management that cannot be addressed in the home. These stays must be in a Medicare-approved facility, which includes a hospice facility, hospital, or skilled nursing facility. Medicare also covers inpatient respite care up to five days in a Medicare-approved facility so that the patient’s usual caregiver can receive some relief from stress and have time to rest. In addition, Medicare pays for covered services for health problems that are not related to the patient’s terminal illness. The patient can continue to receive hospice care as long as the hospice medical director or hospice physician recertifies that the patient is terminally ill. The patient pays nothing for hospice care. However, the patient must pay a copayment of up to $5 for outpatient prescription drugs for pain control and symptom management, and 5 percent of the Medicare-approved amount for inpatient respite care (short-term care from another caregiver so that the regular caregiver can rest). Medicare does not cover room and board in the patient’s home or in another facility where the patient lives, such as a nursing home.

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Payments to Hospitals Hospitals are paid for inpatient admissions by the Medicare prospective payment system (PPS). Under PPS, hospitals are paid a predetermined rate for each Medicare admission. Each patient is classified into a diagnosis related group (DRG) on the basis of clinical information. There are hundreds of DRG categories based on principal diagnosis, secondary diagnoses, surgical procedures, age, sex, and discharge status of the patient. Except for certain patients with exceptionally high costs (called outliers), the hospital is paid a flat rate for each type of care, regardless of the actual services provided. The objective is to provide a financial incentive to hospitals to hold down costs. Hospitals must absorb any costs in excess of the DRG flat amount. Finally, most beneficiaries do not pay premiums for Part A coverage because they paid a payroll tax for Part A coverage when they were working. However, some persons who are not fully insured for Part A can voluntarily enroll for coverage and pay a monthly premium. For 2011, the monthly premium is $248 for beneficiaries with only 30 to 39 credits; for beneficiaries with fewer than 30 credits, the monthly premium is $450.

Medical Insurance (Part B) Medical Insurance (Part B) is a voluntary program that pays for physicians’ services, surgery, medically necessary services and supplies, and preventive services that are not covered by Part A. Coverage

Except for the disabled, most people become eligible for Part B benefits when they first reach age 65. Persons entitled to Part A benefits are automatically enrolled for Part B benefits unless they voluntarily refuse the coverage. The automatic enrollment also applies to the disabled under age 65 when they qualify for Part B benefits after receiving Social Security disability benefits for 24 months. Some people, however, such as those with permanent kidney failure, are not automatically enrolled and must apply for Part B benefits. The initial enrollment period covers a seven-month period that begins three months before the month the individual attains age 65, includes the month in which age 65 is reached, and ends three months after the month the individual attains age 65. Individuals who fail to sign up for Part B when first eligible may have to pay a late enrollment penalty. Monthly Part B premiums are increased 10 percent for each full 12-month period that the individual could have had Part B coverage but did not sign up for it. The late enrollment penalty does not apply to special enrollments. If an individual does not sign up for Part B when first eligible, he or she may be able to sign up during one of the following enrollment periods: • General enrollment period. There is a general enrollment period each year during which individuals can sign up for Part B. However, they may have to pay a late enrollment penalty.

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• Special enrollment period. Individuals may delay signing up for Part B because they or their spouses are still working and are covered by a group health insurance plan at work. Likewise, a disabled individual or family member may be working and has coverage under a group health insurance plan at work. People in these categories can sign up for Part B at any time while they have group health insurance coverage based on current employment, or during the eightmonth period that begins the month after employment ends or the group health insurance coverage ends, whichever occurs first. Covered Services

There are two broad categories of covered services under Part B: (1) medically necessary services and supplies, and (2) preventive services. Medically necessary services and supplies are those things needed to diagnose or treat the patient’s medical condition, and that meet accepted standards of medical practice. Preventive services refer to health care that prevents or detects illness at an early stage when treatment is likely to work best, such as flu shots, Pap smears, and colorectal cancer screenings. Examples of medically necessary services include the following: • Physicians’ services such as diagnosis, treatment, and surgery, including care provided by physician assistants and nurse practitioners • Outpatient hospital services, which refers to services a patient receives as an outpatient as part of a doctor’s care • Surgical procedures provided in an ambulatory surgical center • Limited chiropractic services • Diagnostic tests, including X-rays, MRIs, EKGs, and some other diagnostic tests • Outpatient medical services and supplies, such as X-rays, a cast, or stitches • Physical therapy services • Durable medical equipment • Ambulance services • Blood, which is similar to Part A coverage • Cardiac rehabilitation services • Occupational therapy and speech language pathology services • Surgical dressing services Examples of covered preventive services include the following: • Abdominal aortic aneurysm screening, which is a one-time ultrasound screening for people at risk • Bone density measurement • Diabetes screenings • Flexible sigmodoscopies and screening colonoscopies to detect colon cancer • Flu shots, Pap smears, and pelvic exams (includes clinical breast exam) • Medical nutrition therapy services

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• Prostate cancer screenings • Smoking cessation (counseling to stop smoking) • Welcome to Medicare physical exam, a one-time physical exam for newly covered beneficiaries Part B has numerous exclusions, including routine dental care, dentures, cosmetic surgery, acupuncture, hearing aids, and exams for fitting hearing aids. In addition, Medicare does not cover extended stays in a skilled nursing facility beyond the first 100 days in a benefit period. Finally, beneficiaries with no creditable prescription drug coverage can receive prescription drug coverage (Part D) by joining a Medicare Prescription Drug Plan. These plans are private insurance plans that are Medicare approved. Coverage for prescription drugs is discussed later in the chapter. Amount Paid by Part B

Beneficiaries covered under Part B must pay an annual Part B deductible ($162 in 2011), which is indexed to the growth in Part B spending. Part B then pays 80 percent of the Medicare-approved amount for most physicians’ services, outpatient therapy, certain preventive services, and durable medical equipment. For outpatient mental health services, beneficiaries pay 45 percent of the Medicare-approved amount in 2011. However, there is no charge for certain services, including home health-care services, flu shots, and clinical laboratory services. In addition, beginning January 1, 2011, patients pay nothing for most preventive services if they receive the services from physicians or other health-care providers who accept assignment. Medical payments to physicians are made on an assigned or nonassigned basis. By accepting an assignment, the physician agrees to accept the Medicare-approved amount as payment in full. The patient is not liable for any additional out-of-pocket cost other than the calendar-year deductible and coinsurance payments. However, physicians who do not accept an assignment cannot charge more than 15 percent above the amount non-participating providers are paid (95 percent of the fee schedule amount). Many physicians refuse to accept new Medicare patients because the Medicare-approved amounts are often substantially lower than the physician’s actual cost of treatment. Part B Premiums

Beneficiaries with Part B coverage pay monthly premiums, which are supplemented by the federal government out of its general revenues. Under an earlier law, Part B beneficiaries paid only 25 percent of the cost, and the federal government paid the rest. However, Part B premiums are now means tested based on modified adjusted gross income, and upper-income beneficiaries pay substantially more than 25 percent of the cost. The income reported two years earlier on the beneficiary’s federal income tax return determines the Part B premiums. In 2011, most beneficiaries paid a monthly premium of $96.40 or $110.50 if the

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Social Security Administration withheld the premiums from their benefits, and their annual incomes were $85,000 or less ($170,000 or less for joint filers). In 2011, new Part B beneficiaries paid $115.40 monthly because they did not have the premiums deducted from their social security checks in the previous year. However, for beneficiaries with annual incomes above $85,000 ($170,000 for joint filers), monthly premiums were substantially higher. In 2011, for upper-income beneficiaries, monthly premiums ranged from $161.50 to $369.10.

Financing of Medicare Hospital Insurance (Part A) and Medical Insurance (Part B) are financed differently. Part A is financed largely by a payroll tax paid by covered employers, employees, and the self-employed, plus a relatively small amount of general revenues. The Part A payroll tax contribution rate for covered employees and employers is 1.45 percent on all covered earnings, even those that exceed the maximum Social Security earnings base. The self-employed pay 2.90 percent on all covered earnings. All contributions are deposited into a separate Hospital Insurance Trust Fund. Finally, as stated earlier, persons who are not fully insured can voluntarily elect Part A coverage and pay a monthly premium. Beginning in 2013, the Hospital Insurance payroll tax will be increased 0.9 percent (1.45 percent to 2.35 percent) on earnings over $200,000 for single persons and $250,000 for married couples filing jointly. The additional payroll tax on high-wage earners is part of the financing provisions under the new Patient Protection and Affordable Care Act. As stated earlier, Medical Insurance (Part B) is financed by the monthly premiums paid by covered individuals and by the general revenues of the federal government. All Part B premiums, along with the federal government’s contributions, are deposited in the Supplementary Medical Insurance Trust Fund. All benefits and expenses are paid out of this fund.

Medicare Advantage Plans Medicare Advantage Plans (Part C) are private health plans that are part of the Medicare program. Beneficiaries can elect to be covered under such plans instead of the Original Medicare Plan. Medicare Advantage Plans must cover all services that Original Medicare covers except hospice care. Original Medicare covers hospice care. Medicare Advantage Plans may also include additional benefits, such as prescription drugs, vision benefits, dental care, and health and wellness programs. Most Medicare Advantage Plans include Medicare prescription drug coverage. In most plans, members generally must use plan physicians, hospitals, and other providers or else pay more or all of the costs. In addition, plan members usually pay a monthly premium (in addition to the Part B premium) and copayment or coinsurance charges for covered services. Medicare Advantage includes the following: • Health maintenance organization (HMO) plans

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• Preferred provider organization (PPO) plans • Private fee-for-service (PFFS) plans • Special needs plans (SNP) • Medical savings account (MSA) plans

Health Maintenance Organization (HMO) Plans Medicare HMOs are managed care plans operated by private insurers. Managed care is a generic term to describe a plan in which health care is carefully monitored, and there is great emphasis on controlling costs. Patients generally must receive care from physicians and hospitals that are part of the network. In some HMOs, plan members can go outside the network for certain services, but they typically pay substantially higher out-of-pocket costs for such services. Plan members, however, are covered for emergency or urgently needed care outside of the service area of the HMO. In addition, in most cases, plan members must choose a primary care physician who belongs to the network and receives a referral to see a specialist. However, certain services, such as annual screening mammograms, do not require a referral.

Preferred Provider Organization (PPO) Plans Beneficiaries have the option of receiving care from a Medicare PPO. In addition to covered Medicare service, the PPO may provide additional benefits, such as coverage for prescription drugs or vision care. There are two types of PPOs: (1) regional PPOs, which serve one of 26 regions established by Medicare, and (2) local PPOs, which service the counties that the PPO plan elects to include in its service area. PPO members can see any doctor or healthcare provider that belongs to the plan network. Members can also receive care for covered services outside the network, but they must pay higher out-of-pocket costs. Plan members do not have to choose a primary care physician, and a referral from a primary care physician to see a specialist is not required.

Private Fee-for-Service (PFFS) Plans These plans are offered by private companies. A fee is charged for each service provided. A distinctive feature is that the private company, rather than Medicare, decides how much it will pay as well as the amounts members must pay for the services provided. Members can go to any Medicare-approved doctor or hospital that accepts the plan’s payment terms and agrees to provide treatment. Not all providers will accept the patient.

Special Needs Plans (SNP) This is a special type of plan that provides more focused care for specific groups, such as those who reside in nursing homes, those who are covered under both Medicare and Medicaid, or those with certain chronic conditions or disabling conditions. For example, a special needs plan may exist for beneficiaries with diabetes that includes

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health-care providers with experience in treating diabetes. A special needs plan limits membership to certain groups: (1) people who live in certain institutions, such as nursing homes, or who require nursing care at home; (2) people who are eligible for both Medicare and Medicaid; and (3) people who have one or more specific chronic or disabling conditions, including diabetes, congestive heart failure, a mental health condition, or HIV/AIDS. Members generally must get care and services from physicians or hospitals in the plan’s network (except emergency care, out-of-area urgent care, or out-of-area dialysis). Plans typically have specialists for the diseases or conditions that affect plan members.

Medical Savings Account (MSA) Plans Medical savings account (MSA) plans have two components—a high-deductible health plan and a bank account. Medicare gives the plan a yearly amount for the member’s health care, and the plan deposits part of this money into the member’s account. The money in the account and any interest accrued are not taxable if the money is used for health-care costs. The amount deposited is usually less than the deductible amount, so the member has to pay an out-of-pocket amount before coverage begins. After the deductible is met, the plan provides Medicare-covered services.

Other Medicare Health Plans Other Medicare health plans are not part of Medicare Advantage but are still part of the total Medicare program. These plans include (1) Medicare Cost Plans in which, under one type of plan, members with Part A and Part B receive care from primary care doctors and hospitals that are part of the network but can also go outside the network, in which case the services are covered under Original Medicare, but members must pay the Part B premium and Part A and Part B coinsurance and deductibles; (2) demonstration and pilot programs that test and evaluate recommendations for improving Medicare; and (3) PACE programs (programs of all-inclusive care for the elderly) that combine medical, social, and long-term care services, and prescription drug coverage for frail elderly and disabled people who would otherwise need a nursing home level of care to remain in the community.

Medicare Prescription Drug Coverage Medicare beneficiaries are also eligible for Medicare Prescription Drug Coverage (Part D). To obtain drug coverage, beneficiaries must enroll in plans sponsored by insurance companies or Medicare-approved private companies. There are numerous plans available, and the plans vary in cost and the number of drugs covered. Beneficiaries who are now covered for prescription drugs under the group plans of former employers or labor unions can elect to remain in their present plan. There are two ways to obtain Medicare Prescription Drug Coverage: • Medicare Prescription Drug Plans. Medicare prescription drug plans (also called

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PDPs) are stand-alone plans that can be added to the Original Medicare Plan. Only prescription drugs are covered. These plans can also be used to add drug coverage to some Medicare fee-for-service plans, to some Medicare Cost plans, and to Medicare Medical Savings Account plans. • Medicare Advantage or other Medicare health plans. Medicare Advantage Plans provide prescription drug coverage to their members. Other Medicare health plans may also provide prescription drug coverage to the members. Under these plans, members are covered for all Part A and Part B services, and also have coverage for prescription drugs (Part D).

Cost of Prescription Drug Coverage Beneficiaries pay part of the cost, and Medicare pays part of the cost. Monthly premiums vary depending on the prescriptions used, the plan selected, whether the prescription is filled at a pharmacy or by a network provider, whether the drug is included in the plan’s formulary, and whether Extra Help (discussed later) is provided. The term “formulary” refers to the list of prescription drugs covered by the prescription drug plan. All prescription drug plans must provide at least standard coverage, which Medicare has established. The cost-sharing provisions for the various plans are complex and summarized below: • Annual deductible. A beneficiary may be required to have an annual deductible. For 2011, no plan can have an annual deductible exceeding $310. The deductible changes each year. However, many prescription drug plans do not require a ­deductible. • Copayment or coinsurance charge. After the annual deductible is met, beneficiaries must pay a copayment or coinsurance charge. In some plans, the same copayment amount or coinsurance charge applies to each prescription filled. In other plans, there may be different levels or tiers with different costs, such as generic drugs (tier one), brand-name drugs listed in the formulary (tier two), and brand-name drugs not included in the formulary (tier three). • Coverage gap. Most Medicare drug plans have a coverage gap, which is also called a “donut hole.” This means that after the beneficiary spends a certain amount for covered drugs, he or she must pay the entire drug costs out-of-pocket until a maximum limit is reached. The annual deductible, copayment and coinsurance amounts, and the amount paid while in the coverage gap all count toward the out-of-pocket limit. The limit does not include the monthly premiums. In 2011, once the beneficiary and plan spend $2,840 for covered drugs (including the deductible), the coverage gap is reached. At this point, the beneficiary must pay all drug costs until he or she has spent $4,550 out of pocket. However, in 2011, beneficiaries in the coverage gap will receive a 50 percent discount on covered brand-name prescription drugs at the time of purchase to help pay for drugs in the coverage gap. The discount will increase each year until the coverage gap is eliminated in 2020. After the beneficiary has spent $4,450 out of pocket in 2011, the coverage gap ends.

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From that point, a beneficiary pays only a small copayment for each drug until the end of the year. Low-income beneficiaries do not have a coverage gap, but they generally must pay a small copayment charge until the catastrophic level is reached. • Catastrophic coverage. For 2011, once the beneficiary spends $4,550 out of pocket for the year, the coverage gap ends and catastrophic coverage applies. As stated earlier, the beneficiary then pays only a small coinsurance amount or copayment (such as $6) for each covered drug for the remainder of the year.

Extra Help Program The Medicare prescription drug program has an Extra Help program (also called low-income subsidy) that provides financial help in purchasing prescription drugs for beneficiaries with limited incomes and financial resources. Depending on the beneficiary’s annual income and financial resources, the monthly premiums and yearly deductible are reduced or waived for a basic drug plan. However, in most cases, beneficiaries pay a small copayment charge for each prescription filled. To qualify, in 2011, a single person must have an annual income less than $16,335, and resources must be less than $12,640. A married person living with a spouse and no other dependents must have an annual income less than $22,065, and resources must be less than $25,260.

Medigap Insurance Because of numerous exclusions, deductibles, cost-sharing provisions, and limitation on approved charges, Medicare does not pay all medical expenses. As a result, most Medicare beneficiaries have either post-retirement health benefits from their employers or have purchased a Medigap policy (also known as Medicare Supplement Insurance) that pays part or all of the covered charges not paid by Medicare. Medigap policies are sold by private insurers and are strictly regulated by federal law. Every Medigap policy must follow federal and state laws to protect policyholders, and each policy must be clearly identified as “Medicare Supplement Insurance.” Insurers can sell only standardized policies, which are identified by letters in most states as Plans A through N. Plans E, H, I, and J are no longer available to purchase, but beneficiaries who purchased such plans before June 1, 2010, can keep them. Plans M and N are two new plans. All plans offer the same basic benefits, but some plans pay additional benefits so that policyholders can select the plan that best meets their needs. Insurers must provide an open enrollment period of six months from the date the applicant first enrolls in Medicare Part B and is age 65 or older. Some states have additional open enrollment periods. After the initial enrollment period ends, the policyholder’s option to buy a Medigap policy may be limited.

Care Outside the United States Medicare generally does not pay for medical care received outside the United States (note that Puerto Rico, the Virgin Islands, Guam, American Samoa, and the Northern

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Mariana Islands are part of the United States). However, Medicare may pay for covered health-care services that a beneficiary receives in a foreign hospital (a hospital outside of the United States) in three situations:2 • The individual is in the United States when a medical emergency occurs, and a foreign hospital that can treat the illness or injury is closer than the nearest U.S. hospital. • The individual is in Canada and is traveling without unreasonable delay by the most direct route between Alaska and another state when a medical emergency occurs, and a Canadian hospital that can treat the medical condition is closer than the nearest U.S. hospital. • The individual lives in the United States, and a foreign hospital that can treat the illness or injury is closer to the individual’s home than the nearest U.S. hospital, regardless of whether it is an emergency.

Medicare Savings Programs Many poor or low-income Medicare beneficiaries are unable to pay the various premiums, deductibles, and coinsurance charges under Medicare. Medicare Savings Programs provide financial help with medical and drug costs to eligible low-income beneficiaries. There are four types of Medicare Savings Programs:3 • Qualified Medicare Beneficiary (QMB) program. Under this program, the Medicaid program helps to pay Part A and Part B premiums, deductibles, coinsurance, and copayments for qualified Medicare beneficiaries (QMBs). Medicaid is a state-federal public assistance program that helps pay the medical costs for some people with limited incomes and financial resources. To qualify for QMB benefits, Medicare beneficiaries must be eligible for Part A, even if not enrolled; have limited monthly incomes ($928 for individuals and $1,246 for married couples in 2011); and have limited financial resources ($6,680 for singles and $10,020 for married couples in 2011). • Specified Low-Income Medicare Beneficiary (SLMB) program. This program helps to pay Medicare Part B premiums for low-income beneficiaries with incomes slightly above the poverty line. The SLMB program pays only Part B premiums. To qualify, Medicare beneficiaries must be eligible for Part A benefits, even if not enrolled; monthly income cannot exceed certain limits ($1,109 for individuals and $1,491 for married couples in 2011); and financial resources cannot exceed the limits described earlier. However, if a beneficiary has income from working, he or she may qualify for SLMB benefits even if income is higher that the limits described earlier. • Qualified Individual (QI) program. The QI program pays only for Part B premiums. To qualify, an individual must be eligible for Part A, even if not enrolled, and must apply every year for QI benefits. QI applications are granted on a firstcome, first-served basis, with priority given to people who received benefits the previous year. QI benefits are not available to people who qualify for Medicaid.

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Monthly income cannot exceed certain limits ($1,246 for individuals and $1,675 for married couples in 2010). Financial resources cannot exceed the limits described earlier. • Qualified Disabled and Working Individuals (QDWI) program. This program pays only for Part A premiums. Individuals under age 65 may qualify if (1) they are disabled and working; (2) they lost their premium-free Part A coverage when they returned to work; (3) they are not receiving medical assistance from the state; and (4) they meet the state’s income and resource limits. In 2011, monthly income limits are $3,715 for individuals and $4,989 for married couples. Financial resources cannot exceed the limits described earlier. In addition, as discussed earlier, the Medicare prescription drug program has an Extra Help program that provides financial help for prescription drugs for beneficiaries with limited incomes and financial resources.

Medicare Problems and Issues The Medicare program has several critical problems and issues that merit discussion. They include the following: • Medicare financial crisis • Inadequate payment to physicians and hospitals • Overpayments to Medicare Advantage Plans • Fraud and abuse by health-care providers

Medicare Financial Crisis The 2011 Boards of Trustees reports show that the Medicare program has serious financial problems. Medicare Part A (Hospital Insurance) is currently faced with both a short-range and long-range actuarial deficit.4 Short-Range Financial Outlook (2011–2020)

For the short range, the adequacy of the Hospital Insurance (HI) trust fund can be measured by comparing its assets at the beginning of the year to the projected benefit payments for that year (the trust fund ratio). A trust fund ratio of 100 percent shows that assets are at least equal to projected costs for that year and is a good test of shortterm adequacy. By this measure, the HI trust fund fails the short-range test of financial adequacy; its projected trust fund ratio falls to 86 percent beginning in 2012. A less stringent asset test applies to the Supplementary Medical Insurance (SMI) trust fund for Part B benefits. This is because the major portion of financing comes from Part B premiums and from the general revenues of the federal government, which are automatically adjusted each year to meet expected costs. Also, because the prescription drug program operates through private insurance plans, along with a flexible appropriation for federal costs, the need for a contingency reserve for the

The Original Medicare Plan  235

Part D account is eliminated. However, it should be noted that estimated Part B costs are unrealistically low for 2012 and beyond because the projections assume that the current law will reduce physician fees under the sustainable growth system. For 2012, the estimated reduction in physician fees is 29 percent. This is highly unlikely based on the unwillingness of Congress to enforce earlier reductions in physician fees previously scheduled. As such, the understated physician payments will affect the projected costs for Part B, total SMI, and total Medicare. Long-Range Financial Outlook (2011–2085)

The HI trust fund also fails a long-range actuarial balance test over a 75-year valuation period. The actuarial balance is the difference between annual income and costs, which is expressed as a percentage of taxable payroll, and then summarized over the 75-year projection period. Because the SMI program is balanced annually through premium increases and general revenue transfers, actuarial balance is not a meaningful concept for that program. The HI trust fund has a projected 75-year actuarial deficit equal to 0.79 percent of taxable payroll under the intermediate assumptions, which is larger than the 0.66 percent figure reported in the 2010 report. In addition, the HI trust fund will be exhausted in 2024, which is five years earlier than stated in the 2010 report. The actuarial deficit can be interpreted as the number of percentage points that could either be added to the income rate under current law or subtracted from the cost rate for each of the next 75 years to bring the trust fund into actuarial balance. An actuarial balance of zero would be attained if the amount of trust fund assets at the end of the period are equal to the cost for the following year. Reasons for Higher Medicare Expenditures

In fiscal 2010, Medicare expenditures totaled $524 billion, which represented 15 percent of all federal outlays, exceeded only by Social Security (20 percent) and defense spending (20 percent).5 Medicare expenditures have increased substantially over time for a number of reasons. They include the following:6 • Higher prices of medical services and increased volume and complexity of medical services. The prices of medical services provided to beneficiaries have increased over time because the costs of goods and services to provide those services have also increased. These costs include higher wages paid to nurses, and the higher costs of drugs, supplies, medical equipment, and food. In addition, the increased volume of medical services and complexity of medical services and tests have increased total Medicare spending. • Aging of the population and increased Medicare enrollments. An aging population and increased Medicare enrollments have also increased total Medicare spending. Medicare enrollments increased by an average of 623,000 beneficiaries annually between 1995 and 2009. The impact of an aging population and increased enrollments on increased Medicare spending, however, is viewed as being relatively modest.7

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• Medicare prescription drug benefits (Part D). The prescription drug program (Part D) enacted in 2006 has also increased total Medicare expenditures. Part D benefits accounted for two-thirds of the $72 billion increase from 2005 to 2006.8 • Medicare Advantage Plans. Average payments per enrollee to private Medicare Advantage Plans have exceeded the average payment to beneficiaries enrolled in the Original Medicare program. These excess payments averaged 13 percent in 2010.9 Under current law, projected Medicare costs will increase to 5.6 percent of GDP in 2035 and to 6.2 percent in 2085.10 However, this figure assumes that mandated reductions in the growth of health-care costs under the new health-care reform law are fully implemented, and certain actuarial assumptions are also realized. If the ACA assumptions and actuarial assumptions are not realized, then projected Medicare costs could be significantly higher.

Inadequate Payments to Physicians and Hospitals Another important issue is the inadequate payments to physicians and hospitals, which are less than the actual cost of providing the service or care. Physicians’ Fees

Because of a flawed Medicare formula for determining physician fees, the amounts paid to physicians in Medicare reimbursements are substantially lower than the actual costs of practicing medicine. The result is that a significant percentage of physicians refuse to accept new Medicare patients, or limit the number of Medicare patients they will treat. This can be a serious problem in many rural areas, where the number of physicians may be limited. The Medicare physician fee schedule is updated each year, and is based on a complex formula that includes a targeting standard called the sustainable growth rate (SGR). Under this method, physician fees will be reduced if the cost of payments to all physicians exceeds the SGR. The formula for determining the annual growth in Medicare fees is based on the growth in real gross domestic product, Medicare caseloads, and the cost of practicing medicine. However, the SGR formula does not accurately reflect the number and complexity of medical services and treatments, which have increased over time. Thus, based on the SGR formula, as the number and intensity of medical services grow in one year, the more prices must be cut in the following year. In addition, the formula calls for any excess of cumulative spending since the formula was first adopted in 1998 to be recouped as well.11 As a result, for 2010, the implied reduction in physician fees was 21.2 percent, which was much larger than the recommended cuts in previous years. However, Congress has not applied the fee cuts in the past, but has merely postponed them. In 2010, Congress again suspended application of the SGR formula and increased physician fees by 2.2 percent. The SGR formula, however, remains in the law and causes considerable uncertainty for physi-

The Original Medicare Plan  237

cians. Because the amounts paid are still less than the cost of practicing medicine, many physicians refuse to treat new Medicare patients. Hospital Underpayments

Another part of the problem is the underpayment to hospitals for medical services provided to Medicare and Medicaid patients. Underpayment is the difference between the costs incurred in providing care to Medicare and Medicaid patients and the reimbursement received for delivering care to such patients. A complex formula is used to determine the payments hospitals receive for providing Medicare and Medicaid services, which falls short of the actual cost of providing care. In the aggregate, both Medicare and Medicaid hospital payments are substantially lower than actual costs, as shown by the following:12 • Combined underpayments (Medicare and Medicaid) increased from $3.8 billion in 2000 to $32 billion in 2008. • Hospitals received only 91 cents for each dollar spent on caring for Medicare patients in 2008. • Hospitals received only 89 cents for each dollar spent on caring for Medicaid patients in 2008. • In 2008, 53 percent of hospitals received Medicare payments below cost, while 56 percent of hospitals received Medicaid payments below cost. Underpayment to physicians, hospitals, and other health-care providers produce several undesirable economic effects: (1) cost-shifting from providers to the insured is increased, creating a hidden tax that falls on individuals and families with health insurance; (2) underpayment threatens the financial solvency of some rural hospitals that have a high percentage of Medicare patients; and (3) as stated earlier, many physicians refuse to treat new Medicare and Medicaid patients because of inadequate payments, which restricts access to health care for many patients.

Overpayment to Medicare Advantage Plans Another current problem is the overpayment to Medicare Advantage Plans. As explained earlier, Medicare Advantage Plans are private plans that provide Part A and Part B benefits plus additional benefits, such as prescription drugs, vision coverage, health-care memberships, and other benefits. However, the additional benefits have a cost. As stated previously, in 2010, payments to private Medicare Advantage Plans averaged 13 percent more than it costs to cover the same beneficiary under the Original Medicare Plan. However, even though Medicare Advantage Plans cost more than traditional Medicare, these plans overall do not provide higher-quality care to most beneficiaries. A 2011 study by the Kaiser Family Foundation showed that two-thirds of the enrollees in Medicare Advantage Plans are enrolled in plans with a quality rating of average or below average; only about one-fourth are in plans with a quality rating of above average or excellent.13 In addition, the overpayments averaged

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more than $1,100 for each Medicare Advantage beneficiary in 2010, which resulted in higher premiums for seniors and disabled individuals enrolled in the Original Medicare Plan.14 Finally, in some Medicare Advantage Plans, especially private fee-for-service plans (PFFS plans), a large part of the overpayments go to private insurers rather than to beneficiaries in additional benefits.15 Under the new Affordable Care Act, Medicare payments will be gradually reduced for Medicare Advantage Plans so that the cost of care is more in line with the cost of care to beneficiaries enrolled in the Original Medicare Plan. Medicare Advantage insurers have responded to the reduced payments by increasing premiums for the additional benefits, reducing or eliminating certain benefits, or by requiring higher out-of-pocket payments from beneficiaries.

Fraud and Abuse by Health-Care Providers Another serious problem is the substantial amount of fraud and abuse by health-care providers, as well as erroneous Medicare payments. Hard numbers generally are not available, and estimates vary. It is generally agreed, however, that Medicare fraud is widespread and serious, and that improper payments and waste in the system are considerable. Experts estimate that Medicare fraud, improper payments to providers, and abuse of the system account for 3 percent to 20 percent of all Medicare spending. The improper payments are due to a number of factors, including outright fraud, overpayments to physicians and hospitals, overcharging for specific lab tests, charging for services not performed, overcharging and fraud by home health-care providers, abuses in the payment for durable equipment, and nursing-home abuses. Some examples include the following:16 • Medicare and Medicaid lose an estimated $60 billion or more annually to fraud, including $2.5 billion in South Florida. • Medicare and Medicaid made an estimated $23.7 billion in improper payments in 2007. These included $10.8 billion for Medicare and $12.9 billion for Medicaid. Medicare’s fee-for-service reduced its error rate from 4.4 percent to 3.9 percent. • From 2000 to 2007, Medicare paid 478,500 claims that contained the identification number of dead physicians. The amount paid may exceed $92 million. These claims included the identification numbers of between 16,548 to 18,240 deceased physicians. • Nearly one in three claims (29 percent) paid by Medicare for durable medical equipment was erroneous in fiscal 2006. • Medicare and private health insurers pay up to $16 billion a year for needless imaging tests ordered by doctors. • Medicare paid more than $1 billion in questionable claims for 18 categories of medical supplies for patients who did not appear to need them. The study covered claims between January 2001 and December 2006. The claims included walkers for patients with purported sinus congestion, paraplegia, or shoulder injuries.

The Original Medicare Plan  239

Hundreds of thousands of claims were made for diabetes-related glucose test strips for patients with purported breathing problems, bubonic plague, leprosy, or sexual impotence.

Impact of the Affordable Care Act on Medicare The Affordable Care Act contains numerous provisions that have a significant impact on the benefits provided, quality of care, reduction of costs, and financing of the Medicare program. Some provisions went into effect after enactment of the law in 2010, while others are scheduled to do so in the future. It is beyond the scope of the text to discuss all Medicare provisions in detail; however, the following provisions merit a brief discussion:17 • Rebates for the Part D coverage gap (donut hole). An estimated 4 million beneficiaries reached the Part D prescription coverage gap (donut hole) in 2010. Beneficiaries entering the coverage gap received a $250 rebate check. In 2011, seniors who are in the coverage gap will receive a 50 percent discount on covered brand-name prescription drugs. Over the next 10 years, seniors will receive additional savings on brand-name and generic drugs, so that the donut hole is completely eliminated by 2020. • Cracking down on health-care fraud. Current efforts to fight Medicare fraud have returned more than $2.5 billion to the Medicare Trust Fund. The new law invests additional funds in combating fraud and requires providers to use new screening procedures to detect fraud and waste in Medicare, Medicaid, and the Children’s Health Insurance Program (CHIP). Many provisions became effective when the law was first enacted. • Providing free preventive care for seniors. The new law provides certain free preventive services, including annual wellness visits and personalized prevention plans to seniors on Medicare. This provision became effective in January 2011. • Reducing overpayments to insurers and strengthening Medicare Advantage Plans. The new law gradually reduces overpayments to private insurers that sell Medicare Advantage Plans. As stated earlier, in 2010, Medicare paid private insurers, on average, more than $1,100 more per enrollee for Medicare Advantage Plans than it spent on the Original Medicare Plan. As a result, premiums have increased for all Medicare beneficiaries, including the 77 percent who are not enrolled in Medicare Advantage Plans. However, beneficiaries enrolled in Medicare Advantage Plans will still receive all guaranteed Medicare benefits, and the law also provides bonus payments to Medicare Advantage Plans that provide high-quality care. This provision became effective in 2011. • Improving health-care quality and efficiency. The law creates a new Center for Medicare & Medicaid Services that will test new ways of delivering health care to patients, which are expected to improve the quality of care and slow the rate of growth in Medicare health-care costs. This provision became effective in 2011.

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• Reducing unnecessary hospital readmissions. Care for seniors will be improved to reduce or avoid unnecessary hospital readmissions. The Community Care Transitions Program will help high-risk Medicare beneficiaries who are hospitalized to avoid unnecessary readmission to a hospital by better coordination of care and by connecting patients to services in their communities. This provision became effective in 2011. • New innovations to bring down Medicare costs. The Independent Payment Advisory Board will begin operations to develop and submit proposals to Congress and the president to extend the life of the Medicare Trust Fund. The board will focus on the reduction of waste, recommend ways to reduce costs, improve health outcomes for patients, and expand access to high-quality care. Administrative funding becomes available October 1, 2011. • Linking payments to quality outcomes. The law establishes a hospital Value-Based Purchasing program (VBP) in the Original Medicare Plan, which provides financial incentives to hospitals to improve their quality of care. Hospital performance must be reported publicly, beginning with measures relating to heart attacks, heart failure, pneumonia, surgical care, health-care infections, and patients’ perceptions. This provision becomes effective for payments for discharges occurring on or after October 1, 2012. • Bundling of payments. The law establishes pilot programs to encourage the bundling of payments to health-care providers to improve the coordination and quality of patient care. Under the bundling of payments, physicians, hospitals, and other health-care providers are paid a flat rate for an episode of care rather than under the present system in which each test or service, or bundles of items or services, are billed separately to Medicare. For example, under the present system, a surgical procedure generates multiple claims from multiple providers. Under the proposed system, the entire team would be compensated with a bundled payment that provides incentives to deliver health-care services more efficiently while maintaining or improving the quality. Any savings would be shared with the providers and Medicare. This provision becomes effective no later than January 1, 2013.

Summary • The Original Medicare Plan is the traditional plan run by the federal government that provides Part A and Part B benefits. Hospital Insurance (Part A) provides inpatient hospital care and related post-hospital care for most people age 65 and older. Medical Insurance (Part B) is a voluntary program that pays for physicians’ services, surgery, medically necessary services and supplies, and preventive services that are not covered by Part A. • Beneficiaries covered under Part B must pay an annual Part B deductible, which is indexed to the growth in Part B spending. Part B then pays 80 percent of the Medicare-approved amount for most physicians’ services, outpatient therapy, certain preventive services, and durable medical equipment. • Hospital Insurance (Part A) is financed largely by a payroll tax paid by covered employers, employees, and the self-employed, plus a relatively small amount of general

The Original Medicare Plan  241

revenues. Medical Insurance (Part B) is financed by the monthly premiums paid by covered individuals and by the general revenues of the federal government. • Medicare Advantage (Part C) Plans are private health insurance plans that are part of the Medicare program. Beneficiaries can elect to be covered under such plans instead of the Original Medicare Plan. Medicare Advantage Plans must cover all services that Original Medicare covers except hospice care. However, Medicare Advantage Plans typically provide additional benefits as well. • Medicare Advantage Plans include the following: health maintenance organization (HMO) plans; preferred provider organization (PPO) plans; private fee-forservice (PFFS) plans; special needs plans (SNP), and medical savings account (MSA) plans. • Medicare beneficiaries are also eligible for prescription drug coverage (Part D). To obtain drug coverage, beneficiaries must enroll in plans sponsored by insurance companies or by Medicare-approved private companies. There are numerous plans available, and they vary in cost and the drugs covered. All prescription drug plans must provide at least standard coverage, which Medicare has established. The plans have annual deductible and cost-sharing provisions. Many private plans do not require an annual deductible. • Medicare prescription drug plans (also called PDPs) are stand-alone plans that can be added to the Original Medicare Plan. • Medicare Advantage Plans typically provide prescription drug coverage to their members. Other Medicare health plans may also provide prescription drug coverage to the members. Under these plans, members are covered for all Part A and Part B services, and also have coverage for prescription drugs (Part D). • Medicare generally does not pay for medical care received outside the United States except in cases where the foreign hospital is closer than the nearest U.S. hospital. • Many poor or low-income Medicare beneficiaries are unable to pay the various premiums, deductibles, and coinsurance charges under Medicare. Medicare Savings Programs provide financial help with medical and drug costs to eligible low-income beneficiaries. There are four types of Medicare Savings Programs: (1) Qualified Medicare Beneficiary (QMB) program; (2) Specified Low-Income Medicare Beneficiary (SLMB) program; (3) Qualified Individual (QI) program; and (4) Qualified Disabled and Working Individuals (QDWI) program. • The Medicare program has several critical problems, including the following: (1) Medicare financial crisis; (2) inadequate payments to physicians and hospitals; (3) overpayments to Medicare Advantage Plans; and (4) fraud and abuse by health-care providers. • The Affordable Care Act contains numerous provisions that have a significant impact on Medicare benefits, quality of care, reduction of costs, and financing of the Medicare program. These provisions include rebates for the Part D coverage gap (donut hole); cracking down on health-care fraud; providing free preventive care for seniors; reducing overpayments to Medicare Advantage Plans; improving health-care quality and efficiency; reducing unnecessary hospital readmissions; developing new innovations to reduce Medicare costs; and linking payments to quality outcomes.

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Review Questions 1. Identify the groups that are eligible for Hospital Insurance (Part A). 2. Briefly describe the benefits available under Hospital Insurance (Part A). 3. Briefly describe the benefits available under Medical Insurance (Part B). 4. Describe the major differences between Medicare Advantage Plans and the Original Medicare Plan. 5. Identify the various options available to beneficiaries under Medicare Advantage Plans. 6. a.  Explain how Hospital Insurance (Part A) is financed. b.  Explain how Medical Insurance (Part B) is financed. 7. Identify the costs that beneficiaries must pay under Medical Insurance (Part B). 8. Describe the basic characteristics of the Medicare prescription drug ­program. 9. Explain the financial crisis that Medicare is now experiencing. 10. Briefly describe the impact of the Patient Protection and Affordable Care Act of 2010 on the current Medicare program.

Application Questions 1. The Original Medicare Plan consists of Hospital Insurance (Part A) and Medical Insurance (Part B). For each of the following losses, indicate whether the loss is covered under Medicare. If the loss is covered, indicate whether it is covered under Part A or Part B. (Ignore any deductible or coinsurance requirements.) Treat each event separately. a. Lucille, age 79, is admitted to the emergency room of a local hospital because of severe chest pains. b. Ben, age 63, has prostate cancer and visits an oncologist for treatment. c. Larry, age 59, complained of severe back pain. He was diagnosed as having pancreatic cancer and has a life expectancy of three months. Before he died, he received inpatient treatment at a local hospital for a pain block. d. Don, age 82, has a hearing impairment and obtains a hearing aid from a local firm. e. Betty, age 66, suffered a stroke and has speech impairment. After being released from the hospital, she received care in her home from a licensed speech therapist. f. Michael, age 65, is covered under the Original Medicare Plan. His spouse, age 62, has cancer and requires chemotherapy. g. Virginia, age 52, had lung cancer. She was hospitalized several times over an eight-month period before she died. h. Warren, age 66, has an arthritic hip that makes it painful to walk. He undergoes surgery for a hip replacement. 2. Compare the Original Medicare Plan with Medicare Advantage Plans with respect to each of the following:

Selected References  243

a. Choice of plan coverage b. Benefits provided by the plan c. Need for a Medigap policy

Internet Resources • America’s Health Insurance Plans (AHIP) is a national association that represents nearly 1,300 member companies providing health-care benefits to more than 200 million Americans. AHIP’s principal purpose is to represent the interests of its members on legislative and regulatory issues at the federal and state levels, and with the media, consumers and employers. AHIP provides information and services, such as newsletters, publications, a magazine, and online services, and conducts education, research, and quality assurance programs. Visit the site at www.ahip.org • Centers for Medicare & Medicaid Services is the U.S. federal agency that administers the Medicare program, Medicaid programs, and the Children’s Health Insurance Program. The site provides information on regulation and regulation guidance; research statistics, data, and systems; and outreach and education. Visit the site at www.cms.gov • Families USA works to promote high-quality affordable health care for all Americans. The site provides timely information on the Medicare program and health-care reform. Visit the site at www.familiesusa.org • HealthCare.gov is the official Web site of the federal government that provides detailed information on the new health-care reform law and changes to the Medicare program. Click on “Understanding the New Law” for a convenient source of information concerning the provisions of the new law. Visit the site at www .healthcare.gov • The Henry J. Kaiser Family Foundation is one of the best sources of information concerning health-care reform and changes to Medicare under the new law. Visit the site at www.kff.org • Medicare.gov is the official U.S. government Web site for the Medicare program. The site provides detailed information on Medicare basics, locating health-care providers, frequently asked questions, and Medicare benefits that promote prevention. Visit the site at www.Medicare.gov • StopMedicareFraud is a site sponsored by the U.S. Department of Health and Human Services and U.S. Department of Justice to combat Medicare fraud. The site provides information on detecting and reporting Medicare fraud. Visit the site at www.stopmedicarefraud.gov

Selected References Center on Budget and Policy Priorities. Health Reform Changes to Medicare Advantage Strengthen Medicare and Protect Beneficiaries. Washington, DC, July 27, 2010. Centers for Medicare & Medicaid Services. “Medicare and the New Health Care Law—What It Means for You.” May 2010. ———. “Medicare & You 2012.” CMS product no. 10050–42. August 2011.

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Davis, Karen. A New Era in American Health Care: Realizing the Potential of Reform. The Commonwealth Fund. Washington, DC. June 2010. HealthCare.gov. “Provisions of the Affordable Care Act, by Year.” 2010. Henry J. Kaiser Family Foundation. “Medicare Spending and Financing: A Primer.” February 2011. ———. Issue Brief. “Reaching for the Stars: Quality Ratings of Medicare Advantage Plans.” February 11, 2011. ———. “Summary of New Health Care Reform Law.” April 2011. Medicare Payment Advisory Commission (Medpac). Report to the Congress: Medicare Payment Policy. March 2010. Social Security and Medicare Board of Trustees. “Status of Social Security and Medicare Programs: A Summary of the 2011 Annual Reports.” 2011. Summer, Laura, Jack Hoadley, and Elizabeth Hargrave. The Medicare Part D Low-Income Subsidy Program: Experience to Date and Policy Issues for Consideration. The Henry J. Kaiser Family Foundation, September 2010.

Notes 1. This chapter is based largely on Centers for Medicare & Medicaid Services, Medicare & You 2012, CMS Product no. 10050–42, August 2011; Centers for Medicare & Medicaid Services, “Medicare and the New Health Care Law—What It Means for You,” May 2010; HealthCare.gov, “Provisions of the Affordable Care Act, by Year,” 2010; Henry J. Kaiser Family Foundation, “Summary of New Health Care Reform Law,” April 2011; and U.S. Senate, “Implementation Timeline,” Patient Protection and Affordable Care Act, 2010. 2. Centers for Medicare & Medicaid, “Medicare Coverage Outside the United States.” CMS Product no. 11037, revised September 2010. 3. Medicare.gov, “Help with Medical and Drug Costs,” 2011. 4. The actuarial data cited in this section are based on Social Security and Medicare Boards of Trustees, “Status of Social Security and Medicare Programs: A Summary of the 2011 Annual Reports,” 2011. 5. Henry J. Kaiser Family Foundation, “Medicare Spending and Financing: A Primer.” February 2011, p. 1. 6. Ibid, pp. 3–4. 7. Ibid. 8. Ibid. 9. Ibid. 10. Social Security and Medicare Boards of Trustees, Status of Social Security and Medicare Programs: A Summary of the 2011 Annual Reports, 2011. 11. Henry J. Aaron, “The SGR for Physician Payment—An Indispensable Abomination.” New England Journal of Medicine, July 7, 2010. 12. American Hospital Association, “American Hospital Association Underpayment by Medicare and Medicaid Fact Sheet,” November 2009. 13. Henry J. Kaiser Family Foundation, “Reaching for the Stars: Quality Ratings of Medicare Advantage Plans.” Issue Brief, February 11, 2011. 14. Center on Budget and Policy Priorities, “Health Reform Changes to Medicare Advantage Strengthen Medicare and Protect Beneficiaries.” July 27, 2010. 15. Ibid. 16. Data cited are from Coalition Against Insurance Fraud, www.insurancefraud.org/medicarefraud .htm 17. This section is based on Henry J. Kaiser Family Foundation, “Summary of New Health Care Reform Law.” April, 2011.

11 Problem of Occupational Injury and Disease

Student Learning Objectives After studying this chapter, you should be able to: • Describe the problem of occupational injuries and identify the industries that have high incidence rates for occupational injuries. • Explain the problem of occupational disease and identify the industries with high rates of occupational disease. • Show how the costs of occupational injuries and disease are a financial burden to disabled workers, to employers, and to the economy. • Explain some areas of concern in workplace safety and health, including workplace violence, alcohol and substance abuse on the job, and job stress. • Explain the meaning of risk management and describe the major risk-management measures for reducing workplace accidents and disease. • Describe the basic characteristics of the Occupational Safety and Health Act of 1970. Every year, thousands of workers in the United States die from occupational injuries because of unsafe working conditions and unsafe personal acts on the job. Large numbers of workers are also disabled for one or more days each year due to job-related injuries and disease. In addition to pain and suffering, disabled workers must deal with the loss of earned income, payment of medical expenses, partial or permanent loss of bodily functions or limbs, and job separation. If the injury is especially severe, a disabled employee may undergo a painful and traumatic financial, physical, and emotional readjustment, which can be very hard on younger workers who may have several dependents and may be deeply in debt. Occupational disease is another part of the occupational safety and health problem. Because of emerging technology, some workers may be exposed to new chemical and physical hazards that previously did not exist. In addition, many workers are exposed to toxic substances that are associated with lung diseases, skin diseases, lead poisoning, 245

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and other occupational diseases. Safety engineers earlier were concerned primarily with the problem of occupational accidents and accident prevention. However, current emphasis is on the broader viewpoint of occupational safety and health, which includes the total working environment, plant safety, accident prevention, occupational disease, and all other factors that influence the worker’s health. In this chapter, we examine occupational injury and disease as significant causes of economic insecurity. More specifically, we discuss workplace accidents and disease; the cost to disabled workers, to employers, and to society; risk-management techniques for reducing job-related injuries and disease; and the Occupational Safety and Health Act (OSHA) of 1970.

Occupational Injury Occupational injury is an important cause of economic insecurity in the United States, especially if the injury results in total and permanent disability. According to the Bureau of Labor Statistics, private industry employers reported 3.3 million workplace injury and disease cases in 2009, down from 3.7 million cases in 2008. The recordable injury and incidence rate among private industry employers has declined each year since 2003.1 Despite the recent decline, however, billions of dollars in wages are lost each year due to workplace injuries and disease. As a result, substantial medical costs must be paid, scarce economic resources must be used to pay workers’ compensation premiums and claims, and injured workers may experience considerable physical and mental pain, anguish, and uncertainty of returning to work. A substantial number of workers also die each year as a result of workplace accidents. Preliminary data show that 4,340 fatal work injuries occurred in 2009, down from 5,214 in 2008. Based on the preliminary count, the fatal work injury rate for U.S. workers in 2009 was 3.3 deaths per 100,000 full-time equivalent (FTE) workers, down from 3.7 in 2008. Economic factors played a major role in the decline in fatal work injuries in 2009. Total hours worked declined by 6 percent in 2009 because of depressed business conditions that the economy was experiencing at that time.2 In 2009, highway incidents were the leading cause of all workplace deaths, and are the leading cause of death for workers in the transportation and material moving occupations (drivers, sales workers, and truck drivers). Falls were the second leading cause of all workplace deaths and a major cause of death in the construction industry. Assaults and violent acts (homicide) were the third leading cause of death and an important cause of death in the retail trades. Finally, being struck by an object or equipment was the fourth leading cause of death.3 Efforts to reduce workplace deaths and injuries are encouraging, and workplace fatalities have declined over time. Figure 11.1 shows that the number of workplace fatalities has declined since 1994. The decline is generally due to efforts by employers to increase their profit margins by reducing workplace accidents; education of workers about safety and the enforcement of safety rules; state and federal laws that penalize employers with unsafe working conditions; greater emphasis on loss control and safety programs by workers’ compensation insurers; and increased emphasis on risk-management programs that stress safety. In addition, as stated earlier, the recent

Occupational Disease  247 Figure 11.1  Number of Fatal Work Injuries, 1992–2009* The 2009 preliminary total of 4,340 fatal work injuries represents a 17 percent decrease from the 5,214 fatal work injuries reported for 2008. 7,000

6,632 6,331

6,275 6,202 6,238

6,055 6,054

6,000

5,920 5,915 5,534 5,575

5,764 5,734 5,840 5,657 5,214

5,000 4,340 4,000

3,000

2,000

1,000

0 1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

*Data for 2009 are preliminary. Data for prior years are revised and final. Note: Data from 2001 exclude fatal work injuries resulting from the September 11 terrorist attacks. Source: U.S. Bureau of Labor Statistics, U.S. Department of Labor, 2010.

decline in workplace fatalities in 2009 is due to the 2008–2009 recession and resultant reduction in hours worked in fields such as construction, which reduced the exposure to workplace conditions that might result in death. It is also worthwhile to examine the safety records of key industries. Based on Bureau of Labor Statistics data, certain industries have high fatality rates and are more dangerous to work in than others. Figure 11.2 shows the number and rate of fatal occupational injuries by industry sector for 2009. The right side of the figure shows that industries with relatively high fatality rates include (1) construction; (2) transportation and warehousing; (3) agriculture, forestry, fishing, and the hunting industry; and (4) mining. In contrast, fatality rates are significantly lower in educational and health services, financial activities, and the information and utilities industries.

Occupational Disease Occupational disease is widespread throughout the United States and can occur in virtually any occupation. According to the Bureau of Labor Statistics, workplace

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Figure 11.2  Number and Rate of Fatal Occupational Injuries, by Industry Sector, 2009* Total fatal injures = 4,340 All worker fatal injury rate = 3.3 Although construction had the highest number of fatal injuries in 2009, agriculture, forestry, fishing, and hunting had the highest fatal work injury rate. Number of fatal work injuries Construction

Fatal work injury rate (per 100,000 full-time equivalent workers)

816

9.7 579

Transportation and warehousing

12.1

551

Agriculture, forestry, fishing, and hunting Government

26.0 450

Professional and business services

1.9

394

2.9 304

Manufacturing Retail trade

2.2

291

Leisure and hospitality

2.1 216

2.1

186

Wholesale trade Other services (exc. public admin.)

4.9

166

Educational and health services

2.7

136

Mining

101

Financial activities

101

Information

12.7 1.1 32

1.1

17

Utilities 1000

0.7

750

500

250

1.8 0

10

20

30

*Data for 2009 are preliminary. Source: U.S. Bureau of Labor Statistics, U.S. Department of Labor, 2010.

illnesses accounted for slightly more than 5 percent of the 3.3 million injuries and illness cases reported in 2009.4 Illnesses include skin diseases or disorders, respiratory conditions, poisoning, loss of hearing, and others. Occupational disease is not confined to a single industry but exists in all major industries. However, some industries pose a greater threat to workers’ health than others. Manufacturing, education and health services, and natural resources and mining had relatively high incidence rates of occupational disease in 2009. In contrast, the professional and business services and the finance industry had relatively low incidence rates of occupational disease.5 A wide variety of occupational diseases exists in numerous industries. For example, occupational skin diseases generally are caused by chemicals and by having wet hands for long periods at work. High-risk occupations for skin diseases include hairdressing, health care, catering, and printing. Also, millions of workers are exposed to numerous toxic substances and impurities in the air that are associated with occupational asthma, which includes difficulty breathing, wheezing, coughing, and shortness of breath. Likewise, workers exposed to dusty working conditions in plants and elsewhere can develop asbestosis, which is a latent form of lung cancer. Some coal miners have black lung disease, which is due to inhalation of soft-coal dust and results in chronic coughing and shortness of breath. Byssinosis and silicosis are crippling diseases that

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affect textile and cotton workers and also result in chronic coughing and shortness of breath; construction workers often contract silicosis because of sand blasting. In addition, workers can also become sick and disabled because of chemical or metal poisoning, such as lead poisoning, and from organic compounds or vapors, such as industrial cleaning processes in factories. Farm workers are exposed to pesticides, herbicides, and fungicides, which can cause serious illnesses. Workers employed in the poultry industry have a high rate of carpal tunnel syndrome. Finally, more recently, some workers have experienced various lung diseases because of exposure to microwave popcorn powder. In short, a wide variety of occupational diseases can disable workers and cause substantial economic insecurity.

Areas of Concern In their efforts to provide safe working conditions to workers, employers must deal with several critical problems that increase the probability of a workplace accident and even death. Three important problems that merit discussion include (1) alcohol and drug abuse, (2) workplace violence, and (3) job-related stress.

Alcohol and Drug Abuse There is an ongoing epidemic of alcohol and drug abuse (both illegal drugs and prescription drugs) in the United States. According to the National Council on Alcoholism and Drug Dependence, alcoholism and drug dependence is the number one health problem in the United States.6 There are more deaths and disabilities each year in the United States from alcohol and substance abuse than from any other cause; about 18 million Americans have alcohol problems; about 5 to 6 million Americans have drug problems; more than half of all adults have a family history of alcoholism or problem drinking; and more than one million children live with a parent who is dependent on alcohol or illegal drugs. Alcohol and drug dependency spill over into the workplace, and the costs are enormous. Alcohol and drug abuse costs the U.S. economy an estimated $276 billion each year in lost productivity, health-care expenditures, crime, motor vehicle accidents, and other costs. In addition, many alcoholics and addicts are uninsured and cannot afford the cost of a treatment program. Untreated addiction is more costly than heart disease, diabetes, and cancer combined. It is estimated that every American adult pays nearly $1,000 each year for the damages of addiction.7 Employees with an alcohol or drug problem often go to work hung over from drinking or from using drugs the day before. This is reflected in decreased work productivity, an increase in the number of days absent or late for work, problems with supervisors and other employees, court appearances, and serious health problems. Many alcoholics and addicts are deeply in debt; have serious marital and family problems; and may be facing substantial jail or prison time because of drunk driving, driving on a suspended license, possession of illegal drugs, or dealing drugs. The consequences of alcohol and drug addiction to employers and to society at large are huge. One-quarter of all emergency room admissions, one-third of all sui-

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cides, and more than half of all homicides are alcohol related. Heavy drinking also contributes to illnesses related to each of the top three causes of death—heart disease, cancer, and strokes. Also, more than half of all traffic fatalities are alcohol related; between 48 percent and 64 percent of people who die in fires have blood alcohol levels indicating intoxication; and fetal alcohol syndrome is the leading known cause of mental retardation.8 In addition, many alcoholics and drug addicts drink or use illegal drugs on the job. This is especially dangerous if impaired employees are operating machines or heavy equipment, or are driving company vehicles. Many employers deal with this problem by random drug tests. In addition, most large employers have employee assistance programs by which employees with alcohol or drug problems can receive help by being admitted into a rehabilitation program as an inpatient or outpatient. Employers often give impaired employees the option of participating in a treatment program or of being fired from their jobs. Most employees opt for treatment to keep their jobs.

Workplace Violence Thousands of workers are assaulted or killed each year while at work. There are four categories of violent workplace acts that can result in injury or death to workers: (1) robbery and other business crimes, (2) anger by employees toward employers, (3) domestic quarrels that spill over into the workplace, and (4) terrorism or hate crimes. Workers who are more likely to be assaulted or killed include taxi and delivery truck drivers; police officers; prison guards and corrections officers; employees in nursing homes; and employees in fast-food restaurants, liquor stores, and gas stations. Bureau of Labor Statistics data show that workplace homicides were the third leading cause of job-related deaths in 2009. On the bright side, however, workplace homicides have declined more than 50 percent since 1994.9 The National Council on Compensation Insurance (NCCI) periodically provides statistics and analyses on workplace violence based on information from the Bureau of Labor Statistics. Progress continues to be made in reducing workplace violence, including both homicides and assaults. Workplace homicide rates are trending decidedly lower, down 25 percent between 2000 and 2006. The NCCI report shows the following:10 • Workplace assault rates have been more volatile on a yearly basis, declining 20 percent in 2005 and then turning up 6 percent in 2006. Nationally, assault rates have shown a more consistent downward trend. • Robberies continue to be the major cause of workplace homicides, accounting for roughly 70 percent of such deaths. The primary victims of workplace homicides are in occupations where there is direct customer contact and where cash or other valuables are accessible; these victims include cash register operators, security guards, and taxi drivers. • Workplace assaults continue to be concentrated in the health services, social assistance, and personal care occupations. Workers in nursing homes are major victims, with roughly 50 percent of the assaults in the health-care industry occurring in such facilities.

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• NCCI claims data provide separate breakouts for claims involving an act of crime. Such claims are nine times more likely to involve a fatality than non-crime-related claims. • NCCI data also indicate that nonfatal crime-related claims, on average, involve more serious injuries—particularly to the head and central nervous system—than do non-crime-related claims (where back strains and sprains are more ­prevalent). • In part because of the more serious nature of their injuries, crime-related claims have higher indemnity and medical severity costs per claim than other claims when claims are classified by cause of injury. (Traffic accidents continue to have the highest severity.)

Job-Related Stress Workplace stress also merits discussion. Stress is a costly and widespread problem in the economy today. About one-third of the workers report high levels of stress from their jobs. Workplace stress can result from a mismatch between the demands of the job and the capabilities, resources, or needs of the workers.11 High levels of stress can cause depression, anxiety, post-traumatic stress disorder, fatigue, dissatisfaction, aggression, concentration and memory problems, and drinking and substance abuse problems. Some workers such as firefighters, police officers, and air traffic controllers can develop serious mental and physical problems because of the stress associated with their jobs. Workers in other occupations become ill because of stress associated with terminations, transfers, demotions, layoffs, changes in duties, or criticism by supervisors. In many organizations, workplace stress is a major cause of employee turnover. Some employees have experienced an increase in workplace stress because of the severe financial meltdown and economic downswing in 2008 and 2009. This downswing was the second worst recession in the history of the United States, second only to the Great Depression of the 1930s. More than 15 million workers lost their jobs. In addition to the fear and uncertainty of losing their jobs, workers who retained their jobs were often assigned the workloads of former employees. The additional job responsibilities increased the stress levels of workers, especially if time deadlines were imposed. In workers’ compensation, workplace stress claims are difficult to evaluate and settle because of the critical problems of proving causality and measuring the degree of disability. To be compensable as an occupational disease under a workers’ compensation law, the disability must be due to stress that occurs on the job. Coverage of job-related stress claims varies among the states. For example, Nebraska does not cover psychological stress claims unless there is first a physical injury. As such, it may be extremely difficult for a sick worker to show that the stress that produced the disability is due to conditions on the job. In addition, workplace stress claims present unparalleled opportunities for fraud.

Costs of Occupational Injuries and Disease The total physical, financial, psychological, and social costs of job-related accidents and disease are enormous. These costs fall heavily on disabled workers, employers, and the economy.

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Costs to Disabled Workers Disabled workers and their families bear heavy burdens from job-related accidents or from occupational disease. First, as stated earlier, there is the substantial loss of earned income. Most workers’ compensation cash benefits, however, are paid for temporary total disability claims, and the benefits paid do not restore all of the lost income. In addition, all states require disabled workers to satisfy a waiting period, typically ranging from three to seven days, before weekly cash benefits are paid. However, if the temporary disability continues beyond a certain number of days, temporary total disability benefits are typically paid from the first day of disability. In cases of total permanent disability and permanent job separation, there is a substantial loss of earned income; medical expenses still continue; savings may be depleted; employer contributions to a 401(k) plan or profit-sharing plan terminate; and someone must care for the permanently disabled person. Workers’ compensation benefits do not cover all of these costs. The disabled worker’s family also bears a heavy burden from a job-related injury or disease. In addition to mental pain and anguish, the dependents of a disabled family head may experience uncertainty concerning the future continuation of their income. As a result, the family is exposed to considerable economic insecurity. This is especially true if the family head is totally disabled or dies as a result of a job-related accident or disease.

Costs to Employers Employers also incur substantial costs from job-related accidents and occupational disease. These costs can be classified into two major categories: direct and indirect. Direct costs are the net premiums paid by the firm for workers’ compensation insurance, or, if the firm is self-insured, the actual amounts paid to disabled workers and their dependents under the state’s workers’ compensation law, the amounts paid for medical care, and administrative expenses. Direct costs also include expenditures on safety programs and other preventive measures to reduce accidents and injuries. Indirect costs of occupational injuries and disease include the following: • Lost production at the time of the accident • Extra costs because of overtime • Cost of wages paid to supervisors for time lost from an accident • Cost of training replacement workers • Repair or replacement of damaged parts and equipment • Decreased output after the worker returns to work • Costs of the learning period for a new worker hired • Clerical supervision and accident reports • Possible fines for violation of state and federal safety laws There is also the potential cost of criminal negligence by high-level executives who may be charged or found guilty of violating state or federal safety laws that result in death or injury to employees.

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The indirect costs of job-related accidents can exceed the direct costs incurred by the firm, and can also have a significant impact on the firm’s profits. Thus, when both direct and indirect costs are considered, firms have a strong financial incentive to prevent or reduce occupational injuries and disease.

Costs to the Economy The economy also bears a heavy burden from workplace injuries and disease because of the loss of goods and services that could have been produced if the injuries and deaths had not occurred, as well as other costs incurred. According to the National Safety Council, based on severity, the average economic cost for each workplace death in 2009, including employer costs, was estimated to be $1,330,000. The estimated average economic cost for a disabling work injury, including employer costs, was $53,000 in 2009.12 Estimated economic costs from workplace deaths and disabling injuries totaled $183 billion in 2008, which is an enormous cost to the economy.13 These figures include wage and productivity losses, medical costs, administrative expenses, damage to motor vehicles in workplace accidents, and fire losses. The estimated costs also include employer costs for the time lost by uninjured workers who are directly or indirectly involved in the accident, the cost of time to investigate and write up injury reports, and similar costs.

Reducing Occupational Injuries and Disease Employers have a strong financial incentive to reduce occupational injuries and disease. Three major approaches are the following: • Risk management • Workers’ compensation • Occupational Safety and Health Act of 1970

Risk Management Risk management is widely used today by employers and government entities to reduce occupational injuries and disease. Risk management is a process that identifies major and minor loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures. A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether one occurs. Examples of loss exposure include the possibility of explosion in an oil refinery that kills or injures several workers; the possible collapse of a scaffold used in cleaning windows in a high-rise apartment building; slippery floors that could result in injury to employees; unsafe machines that could crush an employee’s hand or fingers; and infections in hospitals that cause hospital employees to become sick. A risk manager will survey the firm to identify the major and minor loss exposures that could result in an accident or death to employees. The goal is to identify unsafe working conditions or unsafe acts by employees. The risk manager may use risk

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analysis questionnaires and checklists, physical inspections, historical loss data, and other information to identify the major and minor loss exposures. After each exposure is measured and analyzed, the risk manager must then select the appropriate combination of techniques for treating each loss exposure. These techniques can be classified broadly as either risk control or risk financing. Risk control refers to techniques that reduce the frequency or severity of losses, or both. Risk financing refers to techniques that provide for the funding of losses. Risk Control

As stated above, risk-control measures aim at reducing the frequency or severity of losses. Three major risk-control techniques are (1) avoidance, (2) loss prevention, and (3) loss reduction. • Avoidance. Avoidance means a certain loss exposure is never acquired or an existing loss exposure is abandoned. For example, a firm may decide not to use a certain machine or piece of equipment in the production process because of potential injury to employees. • Loss prevention. Loss prevention refers to measures that reduce the frequency of a particular loss. For example, highway accidents are a major cause of death for employees in the transportation and warehousing industries. Measures that reduce truck accidents include driver examinations, zero tolerance for alcohol or drug abuse, mandatory classes on defensive driving, and strict enforcement of safety rules. Likewise, robberies are a major cause of death and injury in fastfood stores, especially stores that remain open 24 hours daily. Employees may be instructed not to resist the gunman but to hand over the cash, which reduces the likelihood that the employee will be injured or killed. Finally, many employers have a policy of random drug testing to reduce the frequency of employee injuries from substance abuse. • Loss reduction. Loss reduction refers to measures that reduce the severity of a loss after it occurs. For example, in professional sports, the incident rate of a disabling injury is relatively high. A major league baseball player who injures his knee and is placed on the 15-day disabled list may wear a knee brace during the healing process, which can reduce the severity of the injury. Likewise, a firm may have in place an emergency disaster plan that specifies a plan of action if a tornado or earthquake occurs and employees are injured or killed. For example, a daily newspaper may have a disaster plan for printing the paper at an alternate location if the main plant is damaged by a fire, tornado, flood, or other causes. As a result, revenues continue, and the total loss is reduced. Such measures reduce the severity of losses after they occur. Risk Financing

As stated earlier, risk financing refers to techniques that provide for the payment of losses after they occur. Major risk-financing techniques for occupational injuries and

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disease are (1) retention, including self-insurance, and (2) workers’ compensation insurance. • Retention. Retention means that the firm retains or pays part or all of the losses that can result from a given loss exposure. For example, a firm may decide to retain the cost of total temporary disability claims up to a certain maximum amount. Companies that use retention commonly purchase excess insurance from a commercial insurer that pays when total workers’ compensation claims exceed the company’s retention limits. If retention is used, the risk manager must have some method for paying losses. Losses can be paid out of the firm’s current operating income, by a funded or unfunded reserve, by a line of credit with a commercial bank, or by a captive insurer. A captive insurer is an insurer owned by a single parent firm, or is a group captive or association owned by several parent firms that is formed for the purpose of insuring the parent firm’s loss exposures. • Self-insurance. Larger firms typically self-insure part or all of the losses that result from occupational injuries or disease. Self-insurance is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. Another name for self-insurance is self-funding. Instead of purchasing workers’ compensation insurance, a firm may self-insure its occupational injuries and disease claims. The firm may also self-insure group health insurance benefits, dental insurance, vision insurance, and prescription drug benefits for employees. Firms often self-insure to save money and control health-care costs. The advantages of self-insurance include savings on loss costs, which include savings on claim costs and loss-adjustment expenses; implementation of risk-control techniques that reduce the frequency or severity of losses; and an increase in the firm’s cash flow. The firm can use the premiums that are usually paid to a workers’ compensation insurer at the beginning of the policy period. • Workers’ compensation insurance. All states except Texas have compulsory workers’ compensation laws that require covered employers to pay benefits to workers who have a covered job-related injury or disease. Texas does not require workers’ compensation. However, employers can elect to provide coverage if desired. Employers can meet their legal obligations to injured workers by purchasing a workers’ compensation policy, by self-insurance, or by purchasing coverage from a competitive or monopolistic state fund in some states. Workers’ compensation insurance pays the benefits that employers are legally obligated to provide to injured workers, which include weekly cash payments, medical care, survivor benefits, and rehabilitation benefits. The benefits paid are based on the liability-without-fault principle. Employers are held absolutely liable for job-related accidents or disease regardless of fault. Injured workers are paid benefits according to the state’s workers’ compensation law and are not required to sue their employers to receive benefits. The benefits are extremely important in providing economic security to injured workers and to surviving family members of workers who die as a result of a workplace accident or disease. Workers’ compensation is a major social insurance program and is discussed in greater detail in Chapter 12.

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Occupational Safety and Health Act of 1970 The Occupational Safety and Health Act of 1970 (OSHA) is an important approach to the problem of job-related injuries and disease. Under the law, federal inspectors can inspect worksites to see if employers are in compliance with specific safety and health standards and have a working environment free of safety and health hazards. When OSHA inspectors find safety violations, employers may be issued citations. OSHA was needed for several reasons. Research in job-related accidents and occupational disease at the state and national levels was not keeping pace with the exploding technology that was creating new physical hazards for American workers. Occupational safety and health standards in many states were narrow, with wide diversity among the states regarding the standards and the extent to which they were enforced. Enforcement in most states was weak, and competent occupational health and safety experts were in short supply; moreover, few states had modernized their occupational health and safety laws to protect workers. Existing state occupational health programs had numerous defects, including insufficient funds and personnel, low salary scales, lack of legislative support and concern regarding the health problems of workers, difficulties in filling staff vacancies, and lack of resources to identify statistically the nature of industrial health problems. Because of these defects, Congress responded by enacting the Occupational Safety and Health Act of 1970. The basic purpose of OSHA is to provide safe and healthful working conditions for workers in the United States by reducing hazards at their places of employment. To fulfill this purpose, OSHA provides for mandatory health and safety standards, research in occupational health and safety, information regarding the causes and prevention of industrial accidents and disease, education for employees and employers, the training of occupational health and safety specialists, and assistance and encouragement to the states to develop effective occupational safety and health programs.

Coverage OSHA covers most private-sector employers and employees in all 50 states, the District of Columbia, and other U.S. jurisdictions either directly by the federal OSHA program or by a state program approved by OSHA. State-run health and safety programs must be at least as effective as the federal OSHA program. State and local government employees are not covered by federal OSHA, but have OSHA protection if they work in a state that has an OSHA-approved program. Five jurisdictions have OSHA-approved plans that cover public sector employees only (Connecticut, Illinois, New Jersey, New York, and the Virgin Islands). Private sector workers in these four states and the Virgin Islands are covered by the federal OSHA program. Federal agencies must have a safety and health program that meets the same standards as those required of private employers. Although OSHA does not fine federal agencies, it does monitor federal agencies and responds to workers’ complaints. The U.S. Postal Service (USPS) is covered by OSHA. OSHA does not cover the self-employed; immediate family members of farm

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employers that do not employ outside employees; and workers protected by another federal agency, such as the Mine Safety and Health Administration, the Federal Aviation Administration, and the Coast Guard.

Federal Safety and Health Standards The Secretary of Labor has the authority to establish occupational safety and health standards. If a business firm violates a safety standard, the Secretary of Labor can issue a citation and notify the firm of a proposed penalty. If the firm objects to either the citation or the proposed penalty, it can appeal the case.

Inspections and Penalties Federal inspectors are authorized to inspect any factory, plant, establishment, construction site, or other area where work is performed. The inspection must be made during regular working hours and in a reasonable manner. Fines and penalties can be imposed for safety violations. Employers can meet with the OSHA agency director to discuss the citation and penalty or can appeal to an administrative law judge. An important provision permits an employee to request a special inspection if he or she believes that an imminent danger exists, or that there is a violation of a safety standard that threatens his or her safety or health. Business firms are expressly forbidden from discharging or discriminating against any employee who exercises this right.

Record Keeping Firms are required to maintain records and periodically issue reports concerning workplace deaths, injuries, and occupational disease. Also, the Secretary of Labor can issue regulations regarding the development of information on the causes and prevention of industrial accidents and disease. Firms must also maintain records on employees who are exposed to toxic materials.

Evaluation of OSHA Since the enactment of OSHA, the nation has made substantial progress in reducing workplace accidents and deaths. Since 1970, the workplace fatality rate has been dramatically reduced and overall injury and illness rates have declined in industries where OSHA has focused its attention. Progress has been notable in certain industries. Brown lung disease has been virtually eliminated in the textile industry, and trenching and excavation fatalities have been significantly reduced. Studies have been conducted on the dangers from prolonged exposure to asbestos, cotton dust, carcinogens, and other toxic substances that were often present in industrial plants. As a result, many hazardous substances and chemicals that threaten the workers’ health are now identified and controlled. On the negative side, however, OSHA has been criticized for not correcting cer-

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tain defects. First, labor unions claim that the statistics on workplace fatalities and disease are substantially understated because many injured workers are pressured into not reporting their injuries.14 It is argued that employers fear higher workers’ compensation rates if more injuries are reported, that employers might be targeted for an OSHA inspection if high injury rates are reported, and that employers could be denied government contracts due to high injury rates. As a result, workers may be encouraged or pressured not to report their injuries. A U.S. Government Accountability Office (GAO) study provides strong support for the preceding viewpoint. A survey of occupational health practitioners (physicians, physicians’ assistants, nurse practitioners) revealed that two-thirds of the practitioners reported observing worker fear of disciplinary action for reporting an injury or illness, and that 46 percent said this fear of disciplinary action had at least a minor impact on the accuracy of employers’ records.15 According to the AFL-CIO, certain employer policies and practices, which discourage the reporting of workplace injuries and illnesses, are widespread and undermine the safety and health of American workers. These practices include financial rewards to individuals and departments for going a certain number of days without an injury, which may discourage some workers from reporting injuries; and programs that discipline or even terminate workers when they report an injury. In addition, foreignborn workers, both legal and undocumented, may not know how to report an injury, and employees do not want to be labeled as accident prone.16 As a result, employees may not report all injuries. Second, critics of OSHA claim that enforcement of the law is weak. In particular, labor unions claim that OSHA fines and penalties are inadequate, especially in the case of workplace fatalities; and that the number of inspectors is inadequate, because to inspect each workplace under OSHA jurisdiction just once would take 137 years at current staffing levels.17 In addition, a study by the GAO found that OSHA does not require inspectors to interview workers during audits of records, which would provide additional information about injuries that do not show up on employer records; and that eight high-hazard worksites cannot be audited or targeted for OSHA enforcement and compliance activities because OSHA has not updated its list of high-hazard industries since 2002.18 Finally, research studies suggest that the safety effects of OSHA enforcement have declined significantly over time. One study showed that OSHA inspections that imposed a penalty reduced injuries by about 19 percent in 1970–1985, but by only 1 percent in 1992–1998.19

Summary • Although more than 3 million occupational injuries and cases of work-related disease occur each year, the recordable injury and incident rate among private industry employers has declined over time. Workplace deaths have also declined over time. • Industries with relatively high fatality rates include (1) construction; (2) transportation and warehousing; (3) agriculture, forestry, fishing, and the hunting

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industry; and (4) mining. In contrast, fatal work injuries are significantly lower in educational and health services, financial activities, and the information and utilities industries. • Problem areas in occupational health and safety include alcohol and drug abuse, workplace violence, and job stress. • Disabled workers and their families bear heavy financial burdens from job-related accidents or from occupational disease. In cases of total permanent disability, there is a substantial loss of earned income; medical expenses continue; savings may be depleted; employer contributions to a 401(k) plan or profit-sharing plan terminate; and someone must care for the permanently disabled person. • Employers also incur substantial costs from workplace accidents and disease. These costs are both direct and indirect. Direct costs include net workers’ compensation premiums, or the amounts paid under a self-insured plan. Indirect costs are costs not covered by workers’ compensation and include lost production, extra costs because of overtime, and training replacement workers. Indirect costs can exceed the direct costs of workplace accidents. • The economy also bears a heavy burden from workplace injuries and disease because of the loss of goods and services that could have been produced, as well as other workplace accident costs. • Risk management is widely used by employers and government entities to reduce occupational injuries and disease. Risk management is a process that identifies major and minor loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures. A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs. • Risk control refers to techniques that reduce the frequency or severity of losses, or both. Risk financing refers to measures that provide for the funding of losses. • Three major risk-control techniques are (1) avoidance, (2) loss prevention, and (3) loss reduction. Avoidance means a certain loss exposure is never acquired, or an existing loss exposure is abandoned. Loss prevention refers to measures that reduce the frequency of a particular loss. Loss reduction refers to measures that reduce the severity of a loss after it occurs. • Major risk-financing techniques for occupational injuries and disease are (1) retention, (2) self-insurance, and (2) workers’ compensation insurance. • Retention means that the firm retains or pays part or all of the losses that can result from a given loss exposure. Self-insurance is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. • The advantages of self-insurance include savings on loss costs, which include savings on claim costs and loss-adjustment expenses; implementation of riskcontrol techniques that reduce the frequency or severity of losses; and an increase in the firm’s cash flow. The firm can use the premiums that are usually paid to a workers’ compensation insurer at the beginning of the policy period. • All states except Texas have compulsory workers’ compensation laws that require

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covered employers to pay benefits to workers who have a job-related injury or disease. Workers’ compensation benefits include weekly cash payments, payment of medical bills, survivor benefits, and rehabilitation benefits. The benefits paid are based on the liability-without-fault principle. Employers are held absolutely liable for job-related accidents or disease regardless of fault. • The basic purpose of the Occupational Safety and Health Act (ODHA) is to provide safe and healthful working conditions for workers by reducing hazards at their employment. The act provides for mandatory health and safety standards, research in occupational health and safety, information regarding the causes and prevention of industrial accidents and disease, education for employees and employers, the training of occupational health and safety specialists, and assistance and encouragement to the states to develop effective occupational safety and health programs.

Review Questions 1. Identify the industries that have relatively high fatality rates. 2. Identify the industries that have relatively high incidence rates for occupational disease. 3. Explain how the costs of occupational injuries and disease are a financial burden to disabled workers, to employers, and to the economy. 4. Explain some problem areas in workplace safety and health, which include alcohol and substance abuse, workplace violence, and job stress. 5. What is the meaning of risk management? 6. Describe the following risk-control techniques for reducing workplace accidents and disease: a.  Avoidance b.  Loss prevention c.  Loss reduction 7. Identify several sources for paying losses if retention is used in a risk-management program. 8. What is the meaning of self-insurance? What are the advantages of selfinsurance? 9. Explain the fundamental principle on which workers’ compensation is based. 10. Describe the basic characteristics of the Occupational Safety and Health Act of 1970.

Application Questions 1. Jeremy, age 45, is the general manager of five fast-food restaurants. Each restaurant has a delivery service for customers who call in orders. Employees drive company cars to deliver the food. Employee turnover is high, and employee applications are not carefully verified. One restaurant has been cited by the city for unsanitary conditions and excessive smoke and odors

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in the kitchen area because of poor ventilation, which caused one employee to seek medical assistance for a lung condition. Another restaurant has been robbed several times during the past five years. The company has also been fined by the federal government for employing undocumented workers. The company’s accountant recommends that the firm establish a risk-management program to deal with these problems. Answer the following questions based on the preceding information. a. Explain the meaning of risk management. b. In the case above, identify several major loss exposures that could result in occupational injury or disease to the employees. c. For each of the loss exposures in (b) above, describe a risk-control technique that could be used to treat the exposure. d. Describe several sources for paying losses if partial retention is used in the risk-management program. e. Explain the advantages of partial retention to the company. 2. A luncheon speaker stated, “most firms have a strong financial incentive to reduce occupational injuries because the indirect costs of workplace accidents can exceed the employers’ direct costs. Risk management can be especially useful in this regard.” a. Describe the direct costs of job-related accidents and occupational disease to employers. b. Describe the indirect costs of job-related accidents and occupational disease to employers. c. Explain several risk-management measures that employers can use to reduce the frequency and severity of workplace accidents and disease.

Internet Resources • The Bureau of Labor Statistics, U.S. Department of Labor, is the premier source for statistics on occupational injuries and disease. The site also provides annual data on workplace fatalities. Visit the site at www.bls.gov • The Insurance Information Institute provides timely information and studies on workers’ compensation programs in the United States, including important problems and issues. Visit the site at www.iii.org • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on social insurance programs, including workers’ compensation, on its Web site, www.nasi.org • The National Council on Compensation Insurance (NCCI) has the nation’s largest database of workers’ compensation insurance information. NCCI analyzes industry trends, prepares rate recommendations, determines the cost of proposed legislation, and provides a variety of services and tools to workers’ compensation insurers. Visit the site at www.ncci.com • The National Institute for Occupational Safety and Health (NIOSH) is the federal agency responsible for conducting research and making recommendations

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for the prevention of work-related injury and illness. Visit the site at www.cdc .gov/niosh. • The Workers’ Compensation Research Institute is an independent, not-forprofit research organization providing high-quality, objective information about public policy issues involving workers’ compensation systems. The institute does not take positions on the issues it researches; rather, it provides information obtained through studies and data collection efforts, which conform to recognized scientific methods. Objectivity is further ensured through rigorous, unbiased peer review procedures. Visit the site www.wcrinet.org

Selected References AFL-CIO. Death on the Job: The Toll of Neglect. 20th ed. Washington, DC, April 2011. Available at http://www.aflcio.org/issues/safety/memorial/doj_2011.pdf Bureau of Labor Statistics. “Workplace Injury and Illness Summary.” News release, October 21, 2010. ———. “Census of Fatal Occupational Injuries Summary, 2009.” News release, August 19, 2010. Insurance Information Institute. “Workers’ Compensation.” January 2011. Available at www.iii.org. This source is periodically updated. McConnell, Campbell R., Stanley L. Brue, and David A. Macpherson. Contemporary Labor Economics. 9th ed. New York: McGraw-Hill/Irwin, 2010. Mealy, Dennis C. “ 2010 State of the Workers’ Compensation Line: Analysis of Workers’ Compensation Results.” National Council on Compensation Insurance, May 14, 2010. Available at www .ncci.com National Council on Compensation Insurance. “NCCI Releases New Study on Workplace Violence.” Research & Outlook, September 2, 2008. Available at www.ncci.com ———. 2010 “Workers’ Compensation Issues Report.” March 2010. Available at www.ncci.com. National Institute for Occupational Safety and Health (NIOSH). “Workplace Stress” NIOSH blog, December 3, 2007. Available at www.cdc.gov/niosh/blog/nsb120307_stress.html National Safety Council. “Estimating the Costs of Unintentional Injuries,” Washington, DC, 2010. National Safety Council. Summary from Injury Facts 2010 Edition. Washington, DC, 2010. U.S. Department of Labor. Occupational Safety and Health Administration. “All About OSHA.” Washington, DC, 2006. U.S. General Accountability Office. “Workplace Safety and Health: Enhancing OSHA’s Records Audit Process Could Improve the Accuracy of Worker Injury and Illness Data.” GAO-10–10, October 2009. Wolf, Martin. “Violence in the Workplace—An Updated Analysis.” NCCI Research Brief, Summer 2008.

Notes 1. Bureau of Labor Statistics, “Workplace Injury and Illness Summary.” News release, October 21, 2010. 2. Bureau of Labor Statistics, “Census of Fatal Occupational Injuries Summary, 2009.” News release, August 19, 2010. 3. Ibid. 4. Bureau of Labor Statistics, “Workplace Injury and Illness Summary.” News release, October 21, 2010. 5. Ibid., Table 6a.

Notes  263 6. National Council on Alcoholism and Drug Dependence, “Alcoholism and Drug Dependence Are America’s Number One Health Problem.” NCADD Fact Sheet, September 2002. 7. Ibid. 8. Ibid. 9. Bureau of Labor Statistics, “Census of Fatal Occupational Injuries Summary, 2009.” News release, August 19, 2010. 10. National Council on Compensation Insurance, “NCCI Releases New Study on Workplace Violence.” Research & Outlook, September 2, 2008. See also Martin Wolf, “Violence in the Workplace—An Updated Analysis.” NCCI Research Brief, Summer 2008. 11. National Institute for Occupational Safety and Health (NIOSH), “Workplace Stress.” NIOSH blog, December 3, 2007. Available at www.cdc.gov/niosh/blog/nsb120307_stress.html 12. National Safety Council, “Estimating the Costs of Unintentional Injuries.” Washington, DC, 2010. 13. National Safety Council, Summary from Injury Facts, 2010 Edition. Washington, DC, 2010. 14. AFL-CIO, “The State of Workers’ Safety and Health” In Death on the Job: The Toll of Neglect. 19th ed., April 2010. Available at www.aflcio.org/issues/safety/memorial/upload/dotj_2011.pdf. 15. U.S. General Accountability Office, “Workplace Safety and Health: Enhancing OSHA’s Records Audit Process Could Improve the Accuracy of Worker Injury and Illness Data.” GAO-10–10, October 2009. 16. AFL-CIO, Death on the Job. 17. Ibid. 18. U.S. General Accountability Office, “Workplace Safety and Health.” 19. Campbell R. McConnell, Stanley L. Brue, and David A. Macpherson, Contemporary Labor Economics. 9th ed. (New York, NY: McGraw-Hill/Irwin, 2010), p. 412.

12 Workers’ Compensation

Student Learning Objectives After studying this chapter, you should be able to: • Explain the fundamental principle of liability without fault on which workers’ compensation is based. • Explain the economic and legal theories that justify the existence of workers’ compensation laws. • Explain the major objectives of workers’ compensation laws. • Describe the basic characteristics of state workers’ compensation laws, including covered occupations, eligibility requirements, types of benefits and financing. • Understand the current problems and issues in workers’ compensation ­insurance. State workers’ compensation laws provide cash benefits, medical care, and rehabilitation services to workers who are disabled from job-related accidents or occupational disease, and death benefits to the survivors of workers killed on the job. Workers’ compensation laws exist in all states, the District of Columbia, American Samoa, Guam, Puerto Rico, and the U.S. Virgin Islands. Federal workers’ compensation laws are also in operation. State workers’ compensation laws differ widely with respect to coverage, adequacy of benefits, rehabilitation services, administration, and other provisions. In this chapter, we analyze the various state workers’ compensation laws. This includes a discussion of the development of workers’ compensation, objectives and theories of workers’ compensation, major provisions of state workers’ compensation laws, and current problems and issues.

Development of Workers’ Compensation Workers’ compensation was the first form of social insurance to develop in the United States. Its development can be conveniently analyzed in three stages: 264

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• Common law of industrial accidents • Enactment of employer liability laws • Emergence of workers’ compensation legislation

Common Law of Industrial Accidents The common law of industrial accidents was the first stage in the development of workers’ compensation in the United States; its application dates back to 1837. Under the common law, workers injured on the job had to sue their employers and prove negligence before they could collect damages. The employer was permitted to use three common law defenses to defeat the worker’s suit for damages. They included the following: • Under the contributory negligence doctrine, injured workers could not collect damages if they contributed in any way to their injuries. • Under the fellow servant doctrine, an injured worker could not collect if the injury resulted from the negligence of fellow workers. • Under the assumption-of-risk doctrine, the injured worker could not collect if he or she had advance knowledge of the dangers inherent in a particular ­occupation. As a result of these harsh defenses, relatively few disabled workers successfully sued their employers and collected damages for their injuries. Lawsuits were expensive; the damage awards were small; legal fees had to be paid out of these small awards; and there was considerable uncertainty regarding the outcome of the lawsuit. The disabled worker had two major problems to solve: the loss of income from the disabling accident and the payment of medical expenses. Under the common law, these problems were largely unsolved, resulting in great economic insecurity and financial hardship to disabled workers.

Enactment of Employer Liability Laws Because of deficiencies in the common law, most states enacted employer liability laws between 1885 and 1910. These laws lessened the severity of the common law defenses and improved the legal position of the injured workers. For example, some states substituted the less severe doctrine of comparative negligence for contributory negligence; the fellow servant doctrine and assumption-of-risk doctrine were modified; employers and employees were denied the right to sign contracts that would relieve employers of legal liability for industrial accidents; and surviving dependents were allowed to sue in death cases. Despite some improvements, however, the fundamental problems experienced by disabled workers still remained. The injured employee still had to sue the employer and prove negligence; the worker still had the problems of maintaining income during the period of disability, as well as payment of medical expenses; and there were still long delays securing court action, lawsuits were costly, and the legal outcome was uncertain.

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Emergence of Workers’ Compensation Legislation The Industrial Revolution, which changed the United States from an agricultural to an industrial economy, caused a great increase in the number of workers killed or disabled in job-related accidents. Because of limitations in both the common law and the employer liability statutes, states began to consider workers’ compensation legislation as a solution to the growing problem of job-related accidents. Workers’ compensation laws existed in Europe in the 1880s, and by 1910, most European countries had enacted some type of law. However, workers’ compensation in the United States developed more slowly. Similar laws were enacted in a number of states by 1911, and by 1920, most states had enacted such laws. Workers’ compensation programs exist in all states today. Workers’ compensation is based on the fundamental principle of liability without fault. The employer is held absolutely liable for the occupational injuries suffered by the workers, regardless of who is at fault. Injured workers are compensated for their injuries according to a schedule of benefits established by law and are not required to sue their employer to receive benefits. The laws provide for the prompt payment of benefits to injured workers regardless of fault and with a minimum of legal formality. In exchange for workers’ compensation benefits, injured workers generally give up their right to sue their employers for additional benefits or liability beyond what is stipulated in the law.

Objectives of Workers’ Compensation Modern workers’ compensation laws have the following objectives:1 • Broad coverage of employees for job-related accidents and disease • Substantial protection against the loss of income • Reasonable and necessary medical care and rehabilitation • Encouragement of safety • Effective delivery system for benefits and services • Reduction in litigation

Broad Coverage for Occupational Injury and Disease One basic objective of a modern workers’ compensation law is to provide broad coverage of employees for occupational injury and disease. This means that workers’ compensation should cover most employees for all job-related injuries and occupational diseases. As a practical matter, the majority of employees in nonagricultural employment are covered for workers’ compensation. About 9 in 10 workers in the nation’s labor force are covered by workers’ compensation laws. However, the states typically exclude certain occupations or provide incomplete coverage for certain occupations. Excluded occupations are discussed later in the chapter.

Substantial Protection Against Loss of Income The second objective is that workers’ compensation benefits should replace a substantial proportion of the disabled worker’s lost earnings. The measure of a worker’s

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economic loss is the lifetime reduction in remuneration because of occupational injury or disease. Gross remuneration consists of basic wages and salaries, irregular wage payments, pay for leave time, and employer contributions for employee benefits and Social Security benefits. The measure of loss, however, is the difference in net remuneration before and after the work-related disability. Net remuneration reflects taxes, job-related expenses, employee benefits that are lost, and uncompensated expenses that result from the disability. This concept can be illustrated by Table 12.1, which indicates the elements of gross and net remuneration before and after the disability. The view that workers’ compensation should restore a large proportion of the disabled worker’s lost remuneration can be justified by two major considerations. First, workers’ compensation is social insurance, not public assistance, and a means test is not required. Public assistance programs provide benefits based on the applicant’s demonstrated need, and a stringent means test must be satisfied. Workers’ compensation benefits, however, should be closely related to the worker’s loss of present and future income and should be considerably higher than a subsistence level of income. Second, in exchange for workers’ compensation benefits, disabled workers generally give up their right to seek redress for economic damages and pain and suffering under the common law. Other social insurance programs, including Social Security and unemployment insurance, do not require the surrender of a valuable legal right in exchange for benefits. As a practical matter, however, both minimum and maximum weekly cash payments must be established. A minimum benefit is necessary to keep the disabled worker off welfare. A maximum limit is necessary to reduce malingering and disincentives to work; some disabled workers may find workers’ compensation benefits more financially rewarding than working. In addition, some argue that a maximum limit on benefits is necessary to reduce employer costs, but this argument unfairly calls upon disabled workers who are highly paid to bear a higher proportion of their lost wages than lower-paid workers.

Reasonable and Necessary Medical Care and Rehabilitation Another objective is to provide reasonable and necessary medical care and rehabilitation services to workers with job-related injuries and disease. The laws require covered employers to pay medical, hospital, and surgical expenses, and other medical bills relating to the job-related injury or disease. Vocational rehabilitation, counseling, guidance, retraining, and other rehabilitation services are also provided to restore injured workers to productive employment. As a result, disabled workers who are returned to productive jobs can experience a feeling of well-being and self-worth; and adequate and prompt rehabilitation services can reduce workers’ compensation costs.

Encouragement of Safety Workers’ compensation programs also encourage the development of effective safety programs to reduce the number of workers who are disabled by job-related injuries

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Table 12.1

Elements of Gross and Net Remuneration Before and After Disability BEFORE IMPAIRMENT

AFTER IMPAIRMENT

+ + +

Basic wages and salaries Irregular wage payments Pay for leave time Employer contributions for supplements

+ + +

Basic wages and salaries Irregular wage payments Pay for leave time Employer contributions for supplements

=

Total remuneration

=

Total remuneration

– –

Taxes Work-related expenses

– – –

Taxes Work-related expenses Expenses caused by injury or disease

=

Net remuneration

=

Net remuneration

Source: National Commission on State Workmen’s Laws, The Report of the National Commission on State Workmen’s Compensation Laws (Washington, DC: U.S. Government Printing Office, 1972), p. 37.

or disease. Safe working conditions are promoted in two ways. First, insurers have loss control and safety engineering programs that reduce the frequency and severity of job-related accidents and occupational disease. Second, experience rating encourages firms to be safety-conscious and to make a determined effort to reduce job-related accidents and occupational disease, since firms with superior accident records pay relatively lower workers’ compensation premiums. The result is often an improvement in the competitive position of firms and industries with superior safety records. Experience rating allocates the costs of job-related accidents and occupational disease to those firms and industries responsible for them, so a firm with a poor safety record may have to increase its prices, thereby losing some customers to other firms with lower rates of injury and disease. An individual firm with a poor safety record will generally have higher costs and lower profits, which weaken its competitive position.

Effective Delivery System Another objective of workers’ compensation is to provide an effective delivery system, by which benefits and services are provided comprehensively and efficiently. Comprehensive performance means that competent personnel should exist in sufficient numbers and quality to carry out the objectives of workers’ compensation programs. High-quality performance is expected of employers, physicians, state courts, and workers’ compensation insurers and agencies. Efficient performance means that the medical services and other services necessary to treat workers with job-related injuries or diseases are provided promptly and economically. Efficiency can be judged by comparing the workers’ compensation program with similar activities outside the system.

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Reduction in Litigation A final objective of workers’ compensation is to reduce litigation. Benefits are paid promptly to injured workers without requiring them to sue their employers and prove negligence. The objective is to reduce or eliminate the payment of legal fees to attorneys and time-consuming and expensive trials and appeals.

Theories of Workers’ Compensation Several legal and economic theories are used to justify the existence of workers’ compensation laws and the liability-without-fault principle on which the system is based.

Occupational Risk Theory The occupational risk theory is based on the premise that each industry should bear the costs of its own occupational disabilities as a cost of production, and that the costs of job-related injuries or disease should, therefore, be reflected in product prices. The occupational risk theory is defective in several respects. First, it suggests that the workers do not bear any of the costs of job-related accidents. This is incorrect. Since workers’ compensation insurance premiums are based on the firm’s payroll, the economic effects are similar to those of a payroll tax; and research studies suggest that, in the long run, most payroll taxes are borne by labor. To the extent that business firms view workers’ compensation premiums as part of the total wage bill, the costs of job-related accidents, as reflected in the premiums paid, may be shifted backward to the workers in the form of lower wages. Second, the occupational risk theory assumes that the costs of job-related accidents or disease are shifted forward in the form of higher product prices. This might be difficult for a firm with a poor accident record if it is part of an industry in which there is vigorous price competition and the demand for the firm’s product is elastic. Under these conditions, some accident costs may indeed be shifted backward to labor. Finally, injured workers generally bear a substantial proportion of the costs associated with workplace accidents or disease because of a waiting period in many jurisdictions, maximum limits on weekly cash benefits, incomplete restoration of the total economic loss, and often inadequate rehabilitation services. These points are discussed in greater detail later in the chapter.

Least Social Cost Theory The least social cost theory is based on the concept that workers’ compensation laws reduce economic losses from industrial accidents to a minimum. Firms have a financial incentive to reduce job-related injuries and disease because of experience-rating provisions in workers’ compensation insurance and because the uninsured costs may equal or exceed the insured costs of occupational accidents.

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Social Compromise Theory The social compromise theory states that workers’ compensation represents a balanced set of sacrifices and gains for both employees and employers. Injured workers are willing to exchange the right to a jury trial in a lawsuit and a potentially larger award for a smaller but certain disability benefit. Firms are more willing to pay some claims where liability may not exist; as such, they can avoid expensive litigation and the payment of a potentially higher judgment if the injured employee won the suit.

State Workers’ Compensation Laws Workers’ compensation provisions vary widely among the states. Variations include type of law, covered occupations, eligibility requirements, types of benefits, secondinjury funds, financing, and administration.2

Type of Law With the exception of Texas, workers’ compensation laws are compulsory in all states. Covered employers must comply with the law by providing injured workers with the benefits that the law requires. Texas has an elective law that allows employers to elect or reject the state plan. If the employer rejects the act and the injured worker sues for damages based on the employer’s negligence, the employer is deprived of the three common law defenses of contributory negligence, fellow servant rule, and assumption of risk.

Compliance with the Law Employers can comply with the law by purchasing a workers’ compensation policy, by self-insuring, or by obtaining protection from a monopoly or competitive state fund. Many firms, especially smaller ones, comply with the law by purchasing a workers’ compensation policy from a private insurer. The policy guarantees payment of the benefits that the employer is legally obligated to pay to injured workers. Self-insurance is permitted in most states. The majority of states also permit group self-insurance for smaller employers who collectively pool their workers’ compensation loss exposures. However, the laws require employers to meet certain requirements. In four states, employers generally must insure in an exclusive or monopoly state fund.3 Proponents of monopoly state funds cite the following benefits: • Workers’ compensation is social insurance, and private insurers should not profit from the business. • Monopoly state funds should have reduced expenses because of economies of scale and no sales costs. • Monopoly state funds may have greater concern for the welfare of workers. As of June 2010, 15 states had competitive state funds that allow employers to purchase workers’ compensation insurance from private insurers or from a com-

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petitive state fund.4 Competitive state funds have been established for the following reasons: • Competitive funds provide a useful standard for measuring the performance of private insurers. • The states want to make certain that all employers can obtain workers’ compensation insurance. • Competitive funds operate more efficiently if they face competition from private insurers. Employers who do not purchase the required insurance are subject to various penalties. Depending on the state, employers are subject to fines, imprisonment, or both; employers are also liable to a suit with defenses abrogated; and some states enjoin employers from doing business in the state until the insurance requirements are met.

Covered Occupations As stated earlier, about 9 out of 10 workers in the nation’s labor force are covered by workers’ compensation insurance. However, the states typically exclude or provide incomplete coverage for certain occupations, including farm workers, domestic employees in private homes, casual employees, independent contractors, self-employed persons with no employees, business owners, officers, and employees who are volunteers. Some states have numerical exemptions by which small firms with a small number of employees (such as three or fewer) are not required to provide workers’ compensation benefits. However, employers can voluntarily cover employees in an exempted class. These groups generally are excluded because workers’ compensation insurance is not needed; costs may be burdensome or excessive; or administrative complexities make coverage difficult. In addition, state laws typically cover all state and local government employees or certain classes of public employees. Minors are also covered for workers’ compensation insurance. Many states provide double compensation or additional benefits if illegally employed minors are injured. Railroad workers in interstate commerce and sailors in the U.S. merchant marine are not covered by workers’ compensation laws but instead are allowed to sue for damages under the Federal Employers Liability Act; such employers are barred from using the common law defenses of contributory negligence, fellow servant rule, and assumption of risk.

Eligibility Requirements Two major eligibility requirements must be met in order to receive workers’ compensation benefits. First, the injured worker must work in a covered occupation. Second, the worker must have a job-related accident or disease. This means that the injury or disease must arise out of and in the course of employment. The courts have gradu-

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ally broadened the meaning of the “course of employment” over time. The following situations are usually covered under a typical workers’ compensation law: • The employee is injured while performing specified duties at a specified ­location. • An employee who travels is injured while engaging in activities that benefit the employer. • The employee sustains a back injury while lifting some heavy boxes. • The employee is on the premises and is injured while going to the work area. • An employee is walking down the stairs in a company building falls and breaks his or her leg. Certain injuries, however, generally are not compensable under a workers’ compensation law. An employee who is injured in an auto accident going to or from work generally is not covered. Injury due to employee intoxication is usually not compensable, and self-inflicted injuries are also excluded. Workers’ compensation also covers occupational disease arising out of and in the course of employment. However, most states do not cover diseases that are considered to be an “ordinary disease of life” or that are not characteristic of the employee’s occupation. In addition, many states impose special restrictions on diseases resulting from exposure to coal, dust, asbestos, silica, or radiation. Many states also have time limits on the filing of claims (such as one to three years) after the last exposure occurs or after the disease manifests itself. Finally, some states consider heart attacks or respiratory conditions for police officers or firefighters to be a presumptive disability.

Types of Benefits Workers’ compensation laws provide four principal benefits. They are as follows: • Unlimited medical care • Weekly disability income benefits • Death benefits • Vocational rehabilitation Unlimited Medical Care

Medical care is generally unlimited in all states without any time or dollar limits. Medical care is expensive and now accounts for more than 50 percent of all incurred losses nationally. Weekly Disability Income Benefits

Weekly disability income benefits are payable after the disabled worker satisfies a waiting period that typically ranges from three to seven days. If the worker is still disabled after a certain number of days or weeks, most states pay benefits retroactively to the date of injury. The weekly benefit amount is based on a percentage of

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the worker’s weekly wage, typically two-thirds, and the degree of disability. Most states have minimum and maximum dollar limits on the weekly benefit amounts. In most jurisdictions, the maximum weekly benefit is automatically adjusted each year based on changes in the state’s average weekly wage. Four classifications of disability are used to determine the weekly benefit amount: • Temporary total disability • Permanent total disability • Temporary partial disability • Permanent partial disability Temporary Total Disability  Most weekly disability income benefits are paid for temporary total disability. The employee is totally disabled but is expected to recover fully and return to work. In 2009, maximum weekly temporary total disability benefits for the states ranged from a high of $1,311 in Iowa to a low of $414 in Mississippi. The average weekly benefit was $763.5 The benefits are paid for the duration of disability. However, some states limit the number of weeks or the total dollar amount that can be paid. Permanent Total Disability  Permanent total disability means that the employee is permanently and totally disabled and is unable to work in gainful employment. Most states pay lifetime benefits. Some states place a time limit or total dollar amount limit on the benefits that can be paid, but the time limits are generally longer and the dollar amounts higher than temporary total disability. Temporary Partial Disability  Temporary partial disability means that the disabled worker has returned to work but is earning less than before and still has not reached maximum recovery. The disabled worker is not able to work the full number of hours and earns less than before. The weekly benefit is a percentage of the difference in earned wages before and after the injury (typically two-thirds) up to the weekly maximum. Permanent Partial Disability  Permanent partial disability claims are very costly and complex to administer. Permanent partial disability means the worker has a permanent impairment but is not completely disabled and is capable of working. The injured worker has reached maximum medical improvement, but has a permanent impairment that allows him or her to return to some type of work at a lower earnings level than prior to the injury. An example is an employee who loses an eye or an arm in a workplace accident. Permanent partial disability cases are of two types: (1) scheduled and (2) nonscheduled. Scheduled injuries are listed in the law and include the loss of an eye, arm, leg, hand, finger, or other body part. In most states, the amount paid for a scheduled injury is determined by multiplying a certain number of weeks, which is based on the body part involved, by the weekly benefit amount. For example, a worker in Nebraska who loses a hand can receive a maximum benefit of $117,425.

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Nonscheduled permanent partial disability benefits are payments for permanent injuries that are not on a schedule, which include injures to the back, head, internal organs, as well as occupational disease. The states use different methods for the payment of unscheduled partial disability benefits, as summarized below:6 • Impairment approach. Some states use an impairment approach to determine the amount paid for an unscheduled permanent partial disability. Benefits are paid according to the degree of impairment. The degree of impairment is typically based on an estimate provided by a medical practitioner who uses an impairment rating guide, such as the rating guide designed by the American Medical Association. For example, assume that an injured worker’s medical condition has stabilized, and that temporary total disability benefits have been terminated. Assume that the worker has 20 percent impairment. If the state statute allows three weeks of benefits for each percentage point of impairment, the worker is entitled to 60 weeks of benefits for the permanent partial disability. • Loss-of-earning-capacity approach. Under this approach, benefits are based on the extent to which the injury or impairment reduces the worker’s ability to earn or compete in the labor market. It involves a forecast of the financial impact that the permanent impairment will have on the disabled worker’s earning capacity. In addition to the degree of impairment, the worker’s age, education and training, occupation, and work history are considered in determining the loss of earning capacity. • Wage-loss approach. Under this approach, in addition to a permanent injury or impairment, the worker must have an actual wage loss to receive benefits. The wage-loss approach pays benefits based on the actual loss of earnings as a result of a permanent impairment. In some states, the benefit for partial permanent disability begins after it has been determined that maximum medical improvement has been attained. In other states, however, temporary total disability benefits continue as long as the worker has not returned to work or can return to work only at reduced earnings. • Combination approach. A small number of jurisdictions use a combination, or bifurcated approach. For example, if the worker returns to work, and earnings are at or near to the pre-injury level of earnings, the permanent partial disability benefit is based on the degree of impairment. If the worker has not yet returned to work, or has returned to work at lower wages, the benefit is based on the loss of earning capacity. Wide Variation for Scheduled Injuries  There is wide variation in benefits paid by the states for scheduled permanent partial injuries. Workers’ compensation laws have schedules that indicate the amounts paid for specific permanent impairments, but these schedules may cover only a relatively small proportion of medically identifiable impairments. The benefits paid for a specific impairment vary widely, depending on the state. The following sampling shows the maximum amounts that can be paid for certain listed impairments in selected states in 2009.

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Loss of Arm at Shoulder

Loss of One Foot

Loss of One Eye

$48,319 332,480 70,228

$24,659 205,645 43,892

$32,958 213,033 35,114

Colorado Illinois Mississippi

Other illustrations are possible, but these should be sufficient. What the preceding data show is that indemnification for a specific permanent impairment varies widely, depending on state statutes and court interpretations. Death Benefits

Death benefits are also payable if the worker is killed on the job. Two types of benefits are paid. First, a burial allowance is paid up to certain maximum amounts, such as $6,000 in Nebraska. Second, cash income payments can be paid to eligible surviving dependents. A weekly benefit based on a proportion of the deceased worker’s wages (typically one-half or two-thirds) is usually paid to a surviving spouse for life or until she or he remarries. Some states pay a lump sum benefit, such as two years of payments, to a surviving spouse if she or he remarries. Benefits typically are paid to the children until age 18, 19, or some older age if in school or disabled. Many states, however, have limits on the maximum dollar amounts or time limits on the duration of benefits. Vocational Rehabilitation

Vocational rehabilitation and counseling services are also available in all states to disabled workers to restore them to productive employment. In addition to weekly disability benefits, workers who are being rehabilitated are compensated for board, lodging, travel, books, and equipment. Some states also pay training allowances.

Coordination with Other Programs Some disabled workers may be eligible for both workers’ compensation and Social Security disability income (DI) benefits. However, the combined benefits may be so high as to discourage working. Social Security disability income benefits are reduced if the combined benefits payable to the worker or to the worker’s family from both programs exceed 80 percent of the worker’s average current earnings. In addition, a majority of jurisdictions have offset provisions that reduce the workers’ compensation benefit if the disabled worker is receiving income from certain other sources. Depending on the state, the reduction may apply to the receipt of Social Security disability or retirement benefits, unemployment compensation, and employer-funded disability benefits. Finally, a disabled worker under age 65 may have a work-related injury or disease that is covered under both workers’ compensation and Medicare. In cases where Medicare benefits are available, it is the secondary payer. The state workers’ compensation program is primary.

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Second-Injury Funds Some states have second-injury funds that apply when a second injury combined with a previous injury results in a disability benefit that is higher than one for the second injury alone. The employer pays only for the disability caused by the second injury, and the second-injury fund pays for the remainder of the benefit award. The purpose is to encourage employers to hire workers with disabilities. If a second-injury fund did not exist, some employers would refuse to hire such workers because of the higher benefits that might have to be paid if a second injury occurred. For example, assume that a worker with a previous injury or impairment is injured in a workplace accident, and that the second injury along with the first injury results in a more severe disability than one caused by the second injury alone. The amount of workers’ compensation benefits that must be paid will be higher than if only the second injury had occurred. Yet, as stated earlier, the employer pays only for the second injury, and the second-injury fund pays the remainder. In recent years, at least 10 states have terminated their second-injury funds. Many believe that second-injury funds are unnecessary because of the passage of the Americans with Disabilities Act (ADA) in 1990, which made the protection provided injured workers by second-injury funds redundant. The legislation protects injured workers against discriminatory practices by employers. The law prohibits employers from discriminating against disabled persons who are qualified to perform the essential functions of a job. The prohibition against discrimination applies to all employment practices, including hiring, firing, promotions, salary, job training, and other conditions of employment.

Financing of Workers’ Compensation Workers’ compensation benefits are financed by employer premiums or by self-insurance payments based on the theory that the costs of job-related accidents or disease are part of the cost of production. The actual workers’ compensation premium paid by employers is based on numerous factors, including the size of payroll, industry, occupation of covered employees, and type of business operations. Smaller firms are class rated. Class rating means all employers in the same class pay the same workers’ compensation rate. Larger firms are subject to experience rating. Experience rating means the classrated premium is adjusted upward or downward depending on the employer’s loss experience. The purpose of experience rating is to encourage loss prevention by providing employers with a financial incentive to prevent or reduce workplace accidents or the severity of such accidents. According to the National Academy of Social Insurance, employers paid a total of $78.9 billion nationwide for workers’ compensation in 2008, a decrease of 6.7 percent from the previous year. However, for the first time, payments for medical care accounted for over half (50.4 percent) of all benefits paid.7 These costs include employer expenditures for workers’ compensation benefits, administrative costs, and insurance premiums. Costs for self-insurers are the cost of benefits paid plus the administrative costs of providing the benefits.

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Administration of Workers’ Compensation Most states use a workers’ compensation board or commission to administer workers’ compensation claims. A few states use the courts to administer the claims. The court must either approve the settlement or, if the parties disagree, resolve the dispute. To receive benefits, the injured worker must file a claim for benefits with the appropriate workers’ compensation agency and give proper notice to the employer or insurer. Most states use the agreement method to settle claims; the injured worker and employer or insurer agree upon on a settlement with a procedure for handling disputes, such as an appeals board or hearing.

Problems and Issues in Workers’ Compensation State workers’ compensation laws have numerous problems. Some problems and issues have persisted for years, and new issues are constantly emerging. While it is beyond the scope of this text to discuss all current problems and issues, certain problems merit a brief discussion, including the following: • Rising share of medical costs to total benefits • Fraud and abuse • Erosion of exclusive remedy doctrine • High fatality rates for Hispanic or Latino workers

Rising Share of Medical Costs to Total Benefits The rising share of medical costs to total benefits is a timely topic. Workers’ compensation claims have two components: (1) payments for lost income (called indemnity payments), and (2) payments for medical care. In the past, indemnity payments have accounted for a larger proportion of total cost than medical care. However, this relationship has changed. According to the National Council on Compensation Insurance (NCCI), medical costs comprised 58 percent of total losses in NCCI states in 2009 compared with only 47 percent in 1989.8 According to NCCI, more than half of the rising share of medical costs can be explained by differences in the inflation rates in medical care and wages. Medical costs are rising more rapidly than wages. As a result, medical costs account for a larger proportion of total costs than indemnity payments, which are based on wages. In addition, medical utilization has increased in recent years. Utilization refers to the number of medical tests and treatments per claim. In recent years, the number of billed treatments per claim has increased, which also helps to explain the rising share of medical costs.9

Fraud and Abuse Fraud and abuse in workers’ compensation remain an important problem. According to the Insurance Information Institute, fraud accounts for 10 percent of all incurred losses and loss adjustment expenses in the property and casualty industry, or about

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$30 billion yearly.10 Of that amount, workers’ compensation fraud accounts for approximately 25 percent, or $7.2 billion yearly, according to the National Insurance Crime Bureau.11 Several types of fraud and abuse practices have been identified. They include the following: • Misclassification of employees. Unethical employers often hire new workers and then classify them as independent contractors rather than employees. Another scheme is to pay workers off the books to reduce the number of employees on the payroll. As a result, unethical employers do not have to pay workers’ compensation premiums for these employees. Misclassification has a significant impact on business firms and misclassified employees. Responsible employers who obey the law may be undercut by unethical competitors who intentionally misclassify employees to reduce their labor costs. Misclassification also makes it possible for unethical employers to exploit vulnerable workers, including low-wage workers and undocumented immigrants, who are not familiar with the laws that apply to employment relationships, including labor laws that protect workers. For example, misclassified workers may not know that workers’ compensation premiums are not being paid. • Phony claims. Some workers fake or exaggerate their injuries and submit phony claims. Examples of phony claims are claims submitted by workers who are injured off the job but allege they were injured at work so that workers’ compensation pays the bill; the faking of soft-tissue injuries in the lower back or neck that are difficult to disprove; and workers who inflate their injuries, such as a worker who has a minor back injury but claims that his or her back is badly strained in order to receive benefits for a longer period. • Premium fraud by employers. Some employers use dishonest techniques to reduce workers’ compensation premiums. Such techniques include misrepresentation and underreporting of payroll; false information about the jobs performed by employees, which produces a lower classification rate; avoidance of the experience modification factor, such as a hazardous company that fires all employees and then rehires them from an employee leasing company; and declaring employees as independent contractors rather than employees, as stated earlier. • Fraud and abuse by physicians, health-care providers, and attorneys. Many physician and chiropractors abuse the system by overcharging for medical services, by billing for services never provided, or by referring the patient to a physician-owned lab where unnecessary tests are performed. Some attorneys and physicians have organized fraudulent claim rings and have actively solicited and colluded on claims. Other physicians have shifted unreimbursed costs from Medicare and Medicaid to workers’ compensation insurers by overcharging for the medical services provided. Workers’ compensation insurers use a wide variety of techniques to reduce fraudulent claims and abuse of the system. Such techniques include special investigative units that target “health-care provider mills,” video surveillance teams to document fraud cases once they are identified, and telephone hotlines by which fraudulent cases and leads can be reported.

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Erosion of Exclusive Remedy Doctrine Another timely issue is the erosion in the exclusive remedy doctrine. Under this doctrine, the injured worker has the right to receive statutory workers’ compensation benefits without proving negligence, but in return gives up the right to sue the employer. In short, workers’ compensation benefits should be the sole and exclusive remedy available to injured workers. The exclusive remedy doctrine, however, has been eroded by court decisions and state law in recent years. Depending on the state and court decisions, injured workers may be able to collect both workers’ compensation benefits and a tort damage award based on negligence. There are numerous exceptions to the exclusive remedy doctrine. It is beyond the scope of the text to discuss these exceptions in detail. However, injured workers have been able to sue for damages based on the following legal doctrines: • Intentional Injury. Injured workers may be able to sue for damages if the employer intentionally causes the injury. For example, in one case, an employer ignored repeated warnings from employees about dangerous chemicals. As a result, the injured employees were allowed to bring a direct action for damages against the employer.12 • Dual Capacity Doctrine. Under this doctrine, the injured worker can sue the employer if the injury arises out of something other than an employer-employee relationship. For example, if the employer produces a product that injures the worker in the course of employment, the injured worker can collect workers’ compensation benefits as an employee. In addition, the injured employee might also be able to sue for damages as a consumer or user of a defective product. In such cases, the injured employee can either collect workers’ compensation benefits or sue the employer as the manufacturer of a defective product. For example, if an employee is injured while mowing the grass around the plant and is using a lawn mower manufactured by the company, the injured employee can either collect workers’ compensation or can sue the employer as the manufacturer of a defective product. • Third-Party-Over Action. A third-party-over action is an action by an injured employee who, after receiving workers’ compensation benefits, sues a third party for contributing to his or her injury. Then, because of some type of contractual relationship between the third party and the employer, the liability is passed back to the employer by prior agreement.13 For example, assume that an employee loses a finger while operating a punch press and then sues the manufacturer of the punch press for the injury. The manufacturer sues the employer and claims that the employer’s failure to provide proper training and supervision caused the injury and not the manufacturer of the punch press.14 The overall result is that the injured worker can receive both workers’ compensation benefits and a tort damage award if the lawsuit is successful.

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High Fatality Rates for Hispanic or Latino Workers Another serious problem is the relatively high workplace death rate for Hispanic or Latino workers. The death rate is disproportionately higher for Hispanic and Latino workers than for non-Hispanic/Latino white, black, or Asian workers. Of the 4,340 workplace fatalities in 2009, Hispanic or Latino workers accounted for 668 fatalities, or 15.4 percent of the total deaths.15 Because of relatively low levels of educational attainment and language barriers, Hispanic and Latino workers are over-represented in relatively low-paying, high-risks jobs. In addition, certain hazardous industries employ a high proportion of Hispanic and Latino workers. Agriculture, construction, and transportation have a relatively high number of workplace deaths and injuries each year, and Hispanic and Latino workers are heavily concentrated in these industries. The major reason for their relatively high fatality and injury rates is that many Hispanic and Latino workers do not speak English, or have limited proficiency in the English language. As a result, such workers may not understand clearly the safety rules and regulations of the company; they may commit unsafe acts on the job because they do not clearly understand directions from supervisors; they may be inadequately trained on the safe use of hazardous machines and equipment because of the language problem; and they may operate machines and equipment in an unsafe manner. The result is a relatively high incidence of workplace injuries and fatalities.

Improving Workers’ Compensation Laws In 1972, the National Commission on State Workmen’s Compensation Laws concluded that workers’ compensation programs were generally inadequate and inequitable, and urged the states to incorporate several important recommendations in their workers’ compensation laws. Since that time, this report has been used as a standard model and measuring tool for determining the effectiveness of current workers’ compensation programs. The essential recommendations made by the commission in 1972 to improve workers’ compensation including the following: 1. Compulsory Coverage. All elective laws should be abolished, and coverage should be compulsory for all employers. This objective generally has been met. All states have compulsory laws except Texas. 2. No Numerical or Occupational Exemptions. Numerical exemptions should be abolished, and all employers of one or more workers should be covered. Also, farm workers should be covered on the same basis as all other employees. Household and casual workers should be covered under workers’ compensation at least to the extent that they are covered by Social Security. All government employees should also be covered. There should be no exemptions for any class of employee, including professional athletes and employees of charitable organizations. 3. Full Coverage of Occupational Disease. Present restrictions on occupational disease should be eliminated, and all occupational diseases should be fully covered.

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4. Full Medical Care and Rehabilitation Services. Medical care and physical rehabilitation services should be provided without any limitations with respect to time or dollar amounts. 5. Choice of Filing a Claim. A worker may travel in several states. The worker should have the option of filing a claim in the state where the injury occurred, where the worker is hired, or where employment is principally localized. 6. Adequate Temporary Total Disability Benefits. A worker who is temporarily and totally disabled should receive, subject to the maximum weekly benefit, a weekly benefit at least equal to 80 percent of the worker’s spendable weekly earnings. The maximum weekly benefit should eventually be increased to at least 100 percent of the state’s average weekly wage. Until the maximum state benefit exceeds 100 percent of the state’s average weekly wage, the weekly benefit should be at least two-thirds of the worker’s gross weekly wage. 7. Adequate Permanent Total Disability Benefits. A worker who is permanently and totally disabled should receive benefits at least equal to two-thirds of the gross weekly wage. The maximum weekly benefit should be at least 100 percent of the state’s average weekly wage. The benefits should be paid for life or for the duration of disability, without any limitations on time or total dollar amount. The definition of permanent total disability used by most states should be retained. 8. Adequate Death Benefits. Surviving dependents should receive at least twothirds of the deceased worker’s gross weekly wage. The maximum weekly benefit should be at least 100 percent of the state’s average weekly wage. The death benefits should be paid for life or until remarriage. In the event of remarriage, two years of benefits should be paid in a lump sum. The death benefits for a dependent child should be paid until age 18 or until age 25 if a full-time student. The commission also made several less essential recommendations for improving state workers’ compensation laws, including the following: 1. Shorter Waiting Period. To reduce the disabled worker’s financial burden, all states should enact a waiting period of not more than three days, with retroactive benefits after two weeks or less of disability. 2. Progressive Increase in Maximum Weekly Benefit. The maximum weekly benefit should be progressively increased to at least 200 percent of the state’s average weekly wage. 3. New Basis for Calculating Benefits. The weekly cash benefit should be equal to 80 percent of the worker’s spendable weekly earnings. Spendable earnings are defined as gross earnings minus payroll taxes and job-related expenses, subject to a maximum weekly benefit. Under this approach, tax considerations or additional benefits for dependents would be unnecessary. 4. Minimum Weekly Death Benefits. Minimum weekly death benefits should be at least 50 percent of the state’s average weekly wage. 5. Coordination with Other Benefits. Social Security benefits should continue to

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be reduced when workers’ compensation benefits are paid for permanent and total disability. But in death cases, workers’ compensation benefits should be reduced if the surviving family receives Social Security payments. 6. Protection Against Erosion of Benefits. Disabled workers who are receiving permanent total disability benefits should have their benefits increased over time in the same proportion as increases in the state’s average weekly wage. 7. Free Choice of Physician. A disabled worker should be allowed to select his or her own physician or choose from a panel of physicians approved by the workers’ compensation agency. 8. Broad Coverage Under Second-Injury Funds. Second-injury funds should provide broad coverage for pre-existing impairments, including epilepsy, polio, arthritis, and heart disease. 9. Medical Rehabilitation Division. Each state should establish a medical rehabilitation division within the workers’ compensation agency to provide effective medical care and vocational rehabilitation services to disabled workers. Special cash maintenance benefits should be provided during the worker’s rehabilitation. 10. Time Limits for Filing Claims. Time limits for filing claims should be liberalized. In the case of occupational disease, a substantial time period may elapse between exposure to a disease-causing substance and the worker’s awareness of the disease. 11. More Effective Administration. Each state should have a workers’ compensation agency staffed by full-time civil service employees and financed by assessments against insurers and self-insurers. 12. Limit on Lump-Sum Settlements. Lump-sum settlements and compromiseand-release agreements, which terminate medical and rehabilitation benefits, should be used rarely, and only after the workers’ compensation agency approves of the settlement. How well have the states met these recommendations? When the National Commission on Workmen’s Compensation Laws first released its report, it made 19 essential recommendations. Fear of imposition of federal standards caused the states to move rapidly. As a result, the average state compliance score with respect to the 19 essential recommendations increased sharply from 6.9 in 1972 to 12.0 in 1980. Since that time, however, there has been little or no overall improvement. The average compliance score was only slightly higher (12.83) as of January 1, 2004.16

Summary • Under the common law, workers injured on the job had to sue their employers and prove negligence. The employer could use three common law defenses to defeat the worker’s suit for damages. Under the contributory negligence doctrine, injured workers could not collect damages if they contributed in any way to their injuries; under the fellow servant doctrine, an injured worker could not

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collect if the injury resulted from the negligence of fellow workers; and under the assumption-of-risk doctrine, the injured worker could not collect if he or she had advance knowledge of the dangers inherent in a particular occupation. • Workers’ compensation is based on the fundamental principle of liability without fault. The employer is held absolutely liable for the occupational injuries suffered by the workers, regardless of who is at fault. • Modern workers’ compensation laws have the following objectives: broad coverage of employees for job-related accidents and disease; substantial protection against the loss of income; adequate medical care and rehabilitation; encouragement of safety; effective delivery system for benefits and services; and reduction in litigation. • Several legal and economic theories are used to justify the existence of workers’ compensation laws. The occupational risk theory is based on the premise that each industry should bear the costs of its own occupational disabilities as a cost of production, and that the costs of job-related injuries or disease should, therefore, be reflected in product prices. The least social cost theory is based on the concept that workers’ compensation laws reduce economic losses from industrial accidents to a minimum. The social compromise theory states that workers’ compensation represents a balanced set of sacrifices and gains for both employees and employers. • Employers can comply with the law by purchasing a workers’ compensation policy, by self-insuring, or by obtaining protection from a monopoly or competitive state fund. • Because of the nature of the work, most states exclude or provide incomplete coverage for workers’ compensation for farm workers, domestic workers, and casual workers. • Two major eligibility requirements must be met to receive workers’ compensation benefits. First, the injured worker must work in a covered occupation. Second, the worker must have a job-related accident or disease. This means that the injury or disease must arise out of and in the course of employment. • Four classifications of disability are used to determine the weekly benefit amount: temporary total; permanent total; temporary partial; and permanent partial. • Workers’ compensation laws provide four principal benefits: unlimited medical care; weekly disability income benefits; death benefits to survivors; and vocational rehabilitation. • Some states have a second-injury fund that applies when a second injury combined with a previous injury results in a disability benefit that is higher than one caused by the second injury alone. The employer pays only for the disability caused by the second injury, and the second-injury fund pays for the remainder of the benefit award. • Smaller firms are class rated; all employers in the same class pay the same workers’ compensation rate. • Larger firms are subject to experience rating, The class-rated premium is adjusted

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upward or downward depending on the employer’s loss experience. The purpose of experience rating is to encourage loss prevention. • State workers’ compensation laws have numerous problems. These include the rising share of medical costs to total benefits, fraud and abuse, erosion of exclusive remedy doctrine, and relatively high fatality rates for Hispanic and Latino workers.

Review Questions 1. Explain the common law of industrial accidents. 2. Explain the liability-without-fault principle on which workers’ compensation is based. 3. Briefly explain the major objectives of workers’ compensation laws. 4. Explain the economic and legal theories on which workers’ compensation is based. 5. Explain how employers can comply with a workers’ compensation law. 6. Explain the eligibility requirements for workers’ compensation benefits. 7. Describe the major benefits under a typical state workers’ compensation law. 8. How is workers’ compensation financed? Explain your answer. 9. Why are workplace fatalities and injuries relatively high for Hispanic and Latino workers? 10. Briefly explain the following workers’ compensation problems: a. Rising share of medical costs to total benefits b. Erosion of exclusive remedy doctrine c. Fraud and abuse

Application Questions 1. Although workers’ compensation laws differ among the states, they have certain common features. Explain whether each of the following persons would be eligible for workers’ compensation benefits. In each case, assume that the disabled worker works in a covered occupation. Treat each event separately. a. Josh, age 22, was driving home after work when a drunk driver failed to stop and smashed into his car. Josh was hospitalized and was off work for three weeks. b. Karen, age 38, worked late on a company report due the next day. When she finished later in the evening, she walked down a flight of stairs to the parking lot, slipped, and fractured her leg. Fortunately, a security guard heard her cries for help. She required surgery and was off work for eight weeks. She also received physical therapy for the fractured leg. c. Scott, age 35, worked for a construction company. While working on the roof of a high-rise apartment building, a gust of wind blew him off the roof

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into an adjacent hole. He died while being transported to a local hospital. Scott was married with two preschool children. d. Pedro, age 22, works for a fast food restaurant. He carelessly spilled hot grease on his arm while removing French fries from a container in which the fries were cooked. He suffered third-degree burns and received emergency treatment at a nearby hospital. He was off work for one week. e. Rudy, age 58, works in a lumberyard. A stack of lumber collapsed and injured his foot. The injured foot did not respond to medical treatment and later had to be amputated. Rudy was off work for one year. He was eligible to receive Social Security disability benefits. 2. Some states have second-injury funds in their workers’ compensation programs. However, in recent years, a number of states have terminated such funds. a. How does a second-injury fund protect injured workers? b. Why have some states terminated their second-injury funds? Explain your answer. 3. Permanent partial workers’ compensation claims are costly and often difficult to administer. The states use different methods to compensate injured workers for such claims. a. What is a permanent partial disability claim? b. Explain the difference between a scheduled injury and nonscheduled ­injury. c. Explain the following methods for compensating workers with a non­ scheduled injury. – Impairment approach – Loss-of-earning-capacity approach – Wage-loss approach

Internet Resources • The Bureau of Labor Statistics of the U.S. Department of Labor is the premier source for statistics on occupational injuries and disease. Its site also provides annual data on workplace fatalities. Visit the site at www.bls.gov • The Insurance Information Institute provides timely information and studies on workers’ compensation programs in the United States, including important problems and issues. Visit the site at www.iii.org • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on social insurance programs on its Web site, including workers’ compensation. Visit the site at www.nasi.org • The National Council on Compensation Insurance (NCCI) has the nation’s largest database of workers’ compensation insurance information. NCCI analyzes industry trends, prepares rate recommendations, determines the cost of proposed legislation, and provides a variety of services and tools to workers’ compensation insurers. Visit the site at www.ncci.com

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• The National Institute for Occupational Safety and Health (NIOSH) is the federal agency responsible for conducting research and making recommendations for the prevention of work-related injury and illness. Visit the site at www.cdc .gov/niosh • The Workers Compensation Research Institute is an independent, not-for-profit research organization providing high-quality, objective information about public policy issues involving workers’ compensation systems. The institute does not take positions on the issues it researches; rather, it provides information obtained through studies and data collection efforts that conform to recognized scientific methods. Objectivity is further ensured through rigorous, unbiased peer review procedures. Visit the site www.wcrinet.org

Selected References AFL-CIO. “The State of Workers’ Safety and Health.” In Death on the Job: The Toll of Neglect. 20th ed., April 2011. Available at www.aflcio.org/issues/safety/memorial/upload/dotj_2011.pdf Barth, Peter. “Compensating Workers for Permanent Partial Disabilities.” Social Security Bulletin 65, no. 4 (2003/2004). Bureau of Labor Statistics. “Workplace Injury and Illness Summary.” News release, October 21, 2010. ———. “Census of Fatal Occupational Injuries Summary, 2009.” News release, August 19, 2010. Burton Jr., John F. “Workers’ Compensation.” In The Handbook of Employee Benefits, ed. Jerry S. Rosenbloom, 6th ed. New York: McGraw-Hill, 2005. Coalition Against Insurance Fraud. “Scam Alerts, Workers’ Compensation Scams.” Available at http:// insurancefraud.org/workers_comp_scams.htm Hartwig, Robert P. Emerging Issues in Workers’ Compensation. Insurance Information Institute, August 14, 2006. Available at www.iii.org Insurance Information Institute. “Insurance Fraud.” June 2010. Available at www.iii.org. This source is periodically updated. ———. “Workers’ Compensation.” June 2010. Available at www.iii.org. This source is periodically updated. Mealy, Dennis C. “ State of the Workers’ Compensation Line 2010.” National Council on Compensation Insurance. 2010. Available at www.ncci.com National Academy of Social Insurance. Workers’ Compensation: Benefits, Coverage, and Costs, 2009. Washington, DC: National Academy of Social Insurance, August 2011. National Commission on State Workmen’s Compensation Laws. The Report of the National Commission on State Workmen Compensation Laws. Washington, DC: U.S. Government Printing Office, 1972. National Council on Compensation Insurance. “2010 Workers’ Compensation Issues Report.” March 2010. Available at www.ncci.com U.S. General Accountability Office. “Workplace Safety and Health: Enhancing OSHA’S Records Audit Process Could Improve the Accuracy of Worker Injury and Illness Data.” GAO-10–10, October 2009. U.S. Chamber of Commerce. 2010 Analysis of Workers’ Compensation Laws. Washington, DC, 2010.

Notes 1. National Commission on State Workmen’s Compensation Laws, The Report of the National Commission on State Workmen Compensation Laws (Washington, DC: U.S. Government Printing Office, 1972).

Notes  287 2. U.S. Chamber of Commerce, 2009 Analysis of Workers’ Compensation Laws (Washington, DC, 2009). 3. North Dakota, Ohio, Washington, and Wyoming. (Compulsory for extra hazardous operations only. Employers with nonhazardous operations can insure with the state fund or elect to go without coverage.) 4. Arizona, California, Colorado, Idaho, Kentucky, Maryland, Minnesota, Montana, New York, Oklahoma, Oregon, Pennsylvania, Texas, Utah, and West Virginia. 5. U.S. Chamber of Commerce, 2009 Analysis of Workers’ Compensation Laws. 6. Peter Barth, “Compensating Workers for Permanent Partial Disabilities.” Social Security Bulletin 65, no. 4 (2003/2004). 7. National Academy of Social Insurance, “Workers’ Compensation Payments for Medical Care Exceed Cash Benefits for the First Time.” Press release, September 9, 2010. 8. Dennis C. Mealy, “ 2010 State of the Workers’ Compensation Line: Analysis of Workers’ Compensation Results.” National Council on Compensation Insurance, May 14, 2010. Available at www .ncci.com 9. National Council on Compensation Insurance, “NCCI Releases Research Study Analyzing the Shift in the Medical Share of Total Benefits.” Research & Outlook, December 10, 2008. Available at www.ncci.com 10. Insurance Information Institute, “Insurance Fraud,” June 2010. Available at www.iii.org. 11. Travelers Insurance, “Risk Control: Managing Workers’ Compensation Fraud,” 2008. 12. Blankenship v. Cincinnati Milacrom Chem. Inc., 69 Ohio St. 2d 608, 433, N.E. 2d 572 (1982). 13. Insurance and Risk Management Glossary, “Third-Party-Over Action.” Available at www .IRMI.com 14. William H. Perkins, “Preconference Workshop 6: Workers’ Compensation.” Paper prepared for International Risk Management Institute (IRMI), 2003. Available at www.IRMI.com 15. Bureau of Labor Statistics, “Census of Fatal Occupational Injuries Summary, 2009.” News release, August 19, 2010, Table 4. 16. National Commission on State Workmen’s Compensation Laws, “State Workers’ Compensation Laws in Effect on January 1, 2004, Compared with the 19 Essential Recommendations of the National Commission on State Workmen’s Compensation Laws,” January 2004. Available at www.­workerscompresources.com/National_Commission_Report/National_Commission/1-2004/ Jan2004_nat_com.htm

13 Problem of Unemployment

Student Learning Objectives After studying this chapter, you should be able to: • • • • • •

Explain how unemployment can cause economic insecurity. Explain the meaning of full employment. Describe the major types of unemployment in the United States. Explain how unemployment is measured. Identify the major groups that have relatively high unemployment rates. Explain the major approaches for reducing unemployment in the United States.

Unemployment is a major cause of economic insecurity in the United States in recent years. In the 2007–2009 recession, the United States experienced a severe financial meltdown and the second worst downswing in its history, next only to the Great Depression of the 1930s. The unemployment rate reached a peak of 10.1 percent in October 2009, and 15.6 million workers lost their jobs. Since that time, the unemployment rate declined slightly to 9.1 percent in August 2011. However, when a broader measure of labor market conditions is used, which includes unemployment and underemployment (discussed later), the broader rate was 16.2 percent.1 Stated differently, more than one in six potential workers was unemployed or underemployed in August 2011. The economic freefall and financial meltdown in the 2007–2009 recession were caused by numerous factors. The housing market collapsed and foreclosures increased sharply; the subprime real-estate market collapsed because many homebuyers with marginal credit records purchased homes they could not afford, or obtained adjustable-rate mortgages they did not understand; and financial institutions generally had loose lending standards and often made predatory mortgage loans or loans where the applicants’ income and assets were not documented. Large numbers of homeowners relied heavily on home equity loans, used credit cards excessively, and defaulted on 288

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their mortgage payments. Investment banks and insurance companies sold complex credit default swaps and other derivatives in largely unregulated markets that resulted in billions of dollars of losses. Commercial banks generally were overleveraged and undercapitalized; numerous banks failed or had to merge with other banks; and credit for small business firms became scarce. Investment banks, insurance companies, and other financial institutions incurred enormous losses in the marketing of complex derivatives. In particular, the American International Group (AIG), the world’s largest insurer, sold large amounts of credit-default swaps through a subsidiary company. As housing prices collapsed, AIG had to post billions of dollars of additional collateral, which produced a liquidity crisis and enormous losses for the company. To prevent bankruptcy, the federal government bailed out AIG by injecting billions of taxpayer dollars by federal loans and an equity stake in the company. Government officials argued that the bailout was necessary because of the worldwide repercussions that would have resulted from the bankruptcy of AIG, and that the global recession that was occurring at that time would have been exacerbated. At the time of writing, the economy is sluggish, and the unemployment rate remains stubbornly high with millions of workers unemployed. Many labor economists believe it will be several years before the economy again attains full employment. As a result, millions of unemployed and underemployed workers are exposed to economic insecurity in at least four ways. The first, obviously, is the loss of earned income. Unless unemployed workers have replacement income from other sources (such as unemployment compensation) or past savings on which to draw, they will be economically insecure. Second, if workers can work only part-time because of a sluggish economy and slow economic growth, work earnings are reduced, and they may be unable to maintain a reasonable standard of living. Third, economic insecurity may result from the uncertainly of income. As stated earlier, during the severe 2007–2009 recession, millions of workers lost their jobs. However, many workers who retained their jobs experienced considerable uncertainty and psychological discomfort because of the fear of being laid off. Finally, some unemployed groups have considerable difficulty in finding new jobs. These groups include workers displaced by technological change, older workers, disadvantaged members of minority groups, and the hard-core unemployed. In this chapter, we examine the nature of the unemployment problem in the U.S. economy in some detail. This involves a discussion of the different types of unemployment, measurement of unemployment, extent of unemployment in the United States, underemployment of workers, groups affected by unemployment, and current approaches for reducing unemployment.

Types of Unemployment For purposes of determining appropriate public policy measures, some logical classification of unemployment is necessary. Although there is some disagreement among economists, full employment can be defined as an unemployment rate between 5 percent and 5.5 percent. Some unemployment is considered normal, because some

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workers are changing jobs and are temporarily unemployed; other workers have seasonal jobs; and younger workers entering the labor force for the first time often have difficulty finding initial employment. Thus, full employment does not mean that 100 percent of the labor force is employed. Economists generally recognize the following types of unemployment: • • • • •

Cyclical unemployment Technological unemployment Structural unemployment Frictional unemployment Seasonal unemployment

Cyclical Unemployment Cyclical unemployment (also called demand-deficient unemployment) is unemployment that results from a deficiency in aggregate demand; that is, total spending in the economy or total aggregate demand for goods and services is insufficient for generating an adequate number of jobs to provide full employment. This type of unemployment can be successfully reduced through appropriate monetary and fiscal policies—in particular, lower interest rates and reduction in income taxes—by which aggregate demand can be stimulated to generate additional jobs. Between 1945 and 2009, the American economy has experienced 11 business cycles. Most cycles have been relatively short, averaging 11 months in duration. The latest cycle, which reached its peak in December 2007 and trough in June 2009, is a major exception. The downswing lasted 18 months, substantially longer and more severe than previous recessions. Fluctuations in the three major components of total aggregate demand—consumer spending, investment spending by business firms, and government spending—often interact to cause severe fluctuations in economic activity. Consumer spending is the most important component and currently accounts for roughly 70 percent of the gross domestic product (GDP). Consumer spending is closely related to jobs and to household income. Small changes in consumer demand, especially in the areas of automobiles, appliances, and other durable goods, can have a large impact on the economy. The second component of aggregate demand—-investment spending by business firms—can also cause economic instability. Firms invest in new plants, machinery and equipment, computer equipment and information systems, and research and development to modernize and expand their productive capacity. The decision to invest depends on numerous variables, including anticipated increases in demand, current capacity utilization rates, interest rates, relative costs of capital and labor, borrowing costs, corporate cash flow, taxes, and business optimism and pessimism. The market for capital goods does not respond instantly and smoothly to changes in these variables. The production of capital goods generally requires long lead times; and spending for capital goods is spread out over long periods. The overall result of these investment decisions is often sharp fluctuations in spending by business firms on capital goods, which can cause considerable instability in the economy.

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Finally, government spending by the federal, state, and local governments also has a significant impact on the economy. In 2009, total spending by federal, state, and local governments accounted for about 20 percent of GDP. In particular, spending by the federal government increased substantially in 2008 and 2009 to reduce the severity of the business recession and high unemployment rates that the economy was experiencing at that time.

Technological Unemployment Technological unemployment is unemployment that results from the displacement of workers by new computer technology, labor-saving machinery, new production techniques, or new management methods. Technological change has both positive and negative effects. On the positive side, menial jobs are eliminated, leisure is increased, and goods and services can be produced at lower cost, which can increase workers’ real income. New technology also creates new jobs in industries that manufacture computers, computer parts, and automated equipment; and skilled workers are needed to maintain and repair complex machines and automated equipment. New jobs are also created for computer programmers and computer specialists. On the negative side, however, technological change can create serious unemployment problems, at least in the short run. New technology can cause entire plants to become obsolete and can substantially change the types of job skills that employers require of new workers. Also, new technology can cause a massive displacement of workers in communities that are dependent on one industry or one plant for ­employment.

Structural Unemployment Structural unemployment can be defined as unemployment that results from a mismatch between the skills required for the available jobs in the community and skills possessed by those seeking work. Structural unemployment can also occur from a mismatch between the geographical location of available jobs and job seekers. Millions of workers in the United States have lost their jobs in recent years because of structural unemployment. This is due to several factors: • Increased imports and competition from foreign countries • Outsourcing of jobs to China and other foreign countries by global corporations because of lower labor costs • Relocation or decline of specific industries and the closing of plants • Permanent changes in demand for a particular product • Exhaustion of natural resources The above factors can cause chronic unemployment in a given geographical area. Displaced workers generally lack the skills needed for the jobs that are available, including jobs in the health-care industry and medical fields; information technology; and jobs as medical technicians, computer technicians, communication specialists,

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and engineering. Thus, there is a mismatch between the skills required for the available jobs and the skills possessed by job seekers, and the workers are structurally unemployed. In addition, workers who live in depressed areas may be unwilling or unable to relocate to new areas with expanding employment opportunities. Finally, some workers are unemployed for months and even years because of poor education, poor work habits and motivation, lack of work skills, alcohol and drug addiction, and inadequate knowledge of job opportunities.

Frictional Unemployment Frictional unemployment refers to temporary unemployment that can result from the changing of jobs. When workers change jobs, they may experience a short period of unemployment. Because of imperfections in the labor market, they cannot find work immediately even if jobs are available. They may not be aware of other jobs, or if they are, they may lack the necessary labor mobility to relocate quickly. Thus, they are temporarily unemployed because of an imperfect job search.

Seasonal Unemployment Finally, seasonal unemployment can result from fluctuations in business activity because of weather, customs, styles, and habits. Agriculture and construction are two important seasonal industries, with wide swings in employment throughout the year.

Measurement of Unemployment Before appropriate public policy solutions for reducing unemployment can be prescribed, the extent of unemployment must be measured. This involves consideration of basic labor force concepts.2

Basic Labor Force Concepts Each month the Bureau of Labor Statistics (BLS) releases monthly statistics on employment, unemployment, people outside the labor force, and other personal and occupational characteristics of the working population. The Census Bureau in its Current Population Survey measures the extent of unemployment in the United States each month. The information is collected from a large national sample of about 60,000 households, or approximately 110,000 individuals. The Census Bureau collects the basic information, which is then submitted to the BLS for analysis, interpretation, and publication. • Employed Persons. Employed persons are all persons who did any work for pay or profit during the survey week; or who worked for at least 15 hours in a familyowned business operated by someone in their household; or who are temporarily

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absent from their regular jobs because of illness, vacation, bad weather, labor management dispute, child-care problems, maternity or paternity leave, job training, or other personal or family reasons, whether or not they are paid for the time off. • Unemployed Persons. Unemployed persons are all persons who did not have a job at all during the survey week, made at least one specific active effort to find a job during the previous four weeks, and are available for work (except for temporary illness). Also counted as unemployed are persons who are waiting to be called back to a job after they were laid off (they are not required to be looking for work to be classified as unemployed). • Labor Force. The labor force comprises all persons classified as employed or unemployed in the civilian noninstitutional population, age 16 and over. Excluded groups are persons under age 16, persons confined to institutions such as nursing homes and prisons, and personnel on active duty in the armed forces. • Unemployment Rate. The unemployment rate is the number of unemployed as a percentage of the civilian labor force. Unemployment rates are also computed for different age groups in the labor force based on sex, age, race, marital status, occupation, and other characteristics. • Not in the Labor Force. Persons not in the labor force are all persons in the civilian noninstitutional population who are neither employed nor unemployed. Discouraged workers (see below) are included in this group. • Marginally Attached to the Labor Force. These groups consists of persons who are not in the labor force but want to work, are available for work, and have looked for a job sometime in the prior 12 months, but were not counted as unemployed because they had not searched for work in the four weeks preceding the survey. • Discouraged Workers. Discouraged workers are a subset of persons marginally attached to the labor force. Among the marginally attached, discouraged workers are not currently looking for work because they believe that no jobs are available for them or there are no jobs for which they would qualify. Although the preceding definitions appear complicated, the basic concepts are not difficult to understand. To summarize: people with jobs are employed; people who do not have jobs and are looking for work are unemployed; and people who are not employed or unemployed are not in the labor force.

Limitations of Unemployment Statistics The official unemployment rate alone has two major limitations. Many economists believe that the total unemployment rate alone is too limited and does not completely reflect the true conditions in the labor markets. First, it is argued that the true unemployment rate is understated because the official definition does not count certain groups as unemployed. These groups include: (1) workers who are classified as marginally attached to the labor force; (2) discouraged workers who drop out of the labor force because they believe that jobs are not available or there are no jobs for

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which they would qualify; and (3) workers employed part-time because their hours were cut or they were unable to find full-time jobs. For these reasons, the Bureau of Labor Statistics has developed a set of alternate measures of labor utilization. There are six measures that range from a limited measure of unemployment that includes only workers who have been unemployed (as officially defined) for 15 weeks or more, to a much broader measure (U-6) that includes (1) total unemployment (as officially defined); (2) all persons marginally attached to the labor force, including discouraged workers; and (3) all workers employed part-time for economic reasons. The broader measure of unemployment clearly shows that unemployment and underemployment in the United States are critical national problems. In August 2011, the official unemployment rate was 9.1 percent, which was still relatively high compared with previous recessions. However, when the broader measurement rate is used, the unemployment and underemployment rate was 16.2 percent,3 or 78 percent higher than the official rate. Second, the unemployment rate alone says nothing about the major groups that have unusually high unemployment rates. The groups include workers with Hispanic or Latino ethnicity (11.3 percent); black or African American workers (16.7 percent); teenagers, 16 to 19 years (25.4 percent); and workers with less than a high school diploma (14.3 percent).4

Unemployment in the United States To determine the magnitude of the unemployment problem, it is necessary to examine the unemployment rate in the United States over time and the economic and social costs of unemployment.

Total Unemployment Rate The level of unemployment in the United States has fluctuated significantly over time. During the Great Depression of the 1930s, when the economy was severely depressed, unemployment reached massive proportions. In 1933, about one in four workers in the civilian labor force was unemployed, often for considerable periods. Since that time, unemployment rates have been more moderate, especially since World War II. Figure 13.1 shows wide fluctuations in the unemployment rate from 1951 through August 2011. The unemployment rate ranged from a low of 2.5 percent in May1953 to a high of 10.8 percent in November 1982. During the 2007–2009 recession in the United States, the unemployment rate reached a high of 10.1 percent in October 2009, and 15.6 million workers were unemployed.

Reasons for Unemployment The BLS also provides statistics on the immediate causes of unemployment, which are divided into four groups. Job losers are unemployed persons who lost their last job involuntarily or who have completed a temporary job. This group also includes persons who are on temporary layoff and expect to return to work, as well as persons

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Figure 13.1  Unemployment Rates in the United States 12

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not on temporary layoff. Workers not on temporary layoff include permanent job losers and persons whose temporary jobs have ended. Job leavers are persons who quit their jobs voluntarily and immediately began looking for work. Reentrants are people who worked previously but were out of the labor force prior to beginning their job search. New entrants are unemployed persons who have never worked and are entering the labor force for the first time. In August 2011, the percentage distribution of the unemployed was classified as follows:5 Job losers and persons who have completed temporary jobs Job leavers Reentrants New entrants

58.8% 6.9% 25.3% 8.9%

The majority of workers lose their jobs because of layoffs or because they have completed temporary jobs. A relatively small proportion of workers are unemployed because they voluntarily quit their jobs. However, as a group, reentrants and new entrants experience considerable unemployment. This group consists mostly of women, who frequently enter and leave the labor force because of family obligations, and younger workers who are seeking their first jobs.

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Duration of Unemployment Some unemployed workers find jobs quickly and are unemployed for only a few weeks. Others are unemployed for several months and eventually exhaust their unemployment benefits. Thus, the duration of unemployment must also be considered when evaluating the impact of unemployment on the economy. For many workers, the duration of unemployment is relatively short. In August 2011, about 20 percent of the unemployed were out of work for five weeks or less. However, it is misleading and incorrect to assume that the duration of unemployment is inconsequential for all workers. In August 2011, a period of high unemployment, about 43 percent of the unemployed were out of work for 27 or more weeks.6 Economic insecurity for the long-term unemployed is severe. A large percentage of unemployed workers exhaust their unemployment benefits, lose their group health insurance and other employee benefits, deplete their savings, incur heavy debts, and experience other financial hardships.

Industries and Unemployment Certain industries experience relatively higher unemployment rates than others. Manufacturing employment is greatly affected by business cycles, particularly in firms manufacturing durable goods that have wide fluctuations in consumer demand, such as automobiles and appliances. Workers in the highly seasonal construction industry also experience high rates of unemployment, as do workers employed in farming, fishing, and forestry occupations. In contrast, workers in finance and insurance, education and health services, and government have considerably lower unemployment rates.

Location of Unemployment Unemployment is not evenly distributed throughout the country. Certain areas experience substantially higher unemployment rates than the national unemployment rate. In July 2011, 117 metropolitan areas reported jobless rates of at least 10 percent. Cities with abnormally high unemployment rates included the following:7 El Centro, California Yuma, Arizona Yuba City, California Merced, California Palm Coast, Florida Las Vegas-Paradise, Nevada Detroit-Warren-Livoni, Michigan Flint, Michigan Rockford, Illinois Mansfield, Ohio

30.8% 30.0% 18.7% 18.7% 14.7% 14.0% 14.1% 12.5% 12.1% 11.4%

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In addition, among the sections of any individual city, unemployment varies greatly. The rates are highest in urban poverty areas and decline as one moves out to the suburbs.

Costs of Unemployment Widespread unemployment is costly to the economy, to the individuals and families directly affected, and to society. These costs are both economic and noneconomic. • Economic costs. Unemployment has some direct and real costs to the economy. First, there is the loss of gross domestic product that could have been produced if all economic resources had been fully employed. Because of underutilization of labor and high unemployment rates, the economy is unable to attain its full production potential, and the GDP is less than it otherwise would be. Second, extended unemployment causes millions of years of labor to be lost forever. Labor is a perishable commodity in the sense that it cannot be stored up. An hour of human labor, once lost because of unemployment, is lost forever. Finally, extended unemployment retards economic growth; sustained economic growth is necessary for full employment and a higher standard of living. The economy does not attain its true growth potential if workers are unemployed or underutilized. • Noneconomic costs. There are certain noneconomic costs of unemployment that fall heavily on individuals, families, and society. When people are unemployed for extended periods, skilled workers may experience some deterioration in their skills; others become depressed and develop a negative attitude toward life. In addition, prolonged unemployment can result in lower self-esteem; friction in the family; an increase in alcoholism, drug abuse, and divorce; domestic violence, including child abuse; health problems; and deterioration of family life.

Underemployment of Human Resources Unemployment is only one form of underutilization of human resources; underemployment must also be considered. Wasted human resources are evident in the large numbers of employed who are working in jobs that do not utilize their full skills; those who are marginally attached to the labor force but still desire to work, including discouraged workers; and those involuntarily employed in part-time positions. Thus, underemployment can be classified into three major categories: • Workers employed below their actual or potential skill level • People outside the labor force seeking work • Involuntary part-time work

Workers Employed Below Their Skill Level The employment of workers below their actual or potential skill level is impossible to measure adequately; strictly speaking, there are relatively few people who are not underemployed to some extent. However, underemployment can result from high

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unemployment that forces some workers to accept jobs in which their skills are not completely utilized. Underemployment can also result from racial and sex discrimination, poor education, inadequate diet, and inadequate medical care.

People Outside the Labor Force Seeking Work Many people who are neither working nor currently seeking jobs would like to work. This includes workers who are marginally attached to the labor force and discouraged workers. As stated earlier, the marginally attached are people who are not in the labor force but want to work, are available for work, and have looked for a job sometime in the prior 12 months. However, they were not counted as unemployed because they had not searched for work in the four weeks preceding the survey. Also, as stated earlier, discouraged workers are considered a subset of the marginally attached. Discouraged workers are not currently looking for work, specifically because they believe that no jobs are available for them, or there are no jobs for which they would qualify. In addition, many homemakers with family responsibilities are prevented from working because they must care for their children. Also, illness and disability prevent some people from working in physically demanding jobs, and long-term disabilities dissuade some people from even seeking work.

Involuntary Part-Time Work Millions of workers who want to work full time are working part time because fulltime jobs are not available, or because their regular workweek has been reduced below 35 hours for economic reasons, such as slack work or poor business conditions. In August 2011, about 8.8 million workers were working part time because of economic reasons.8

Who Are the Unemployed? Unemployment affects certain groups more severely than others. Groups that have experienced relatively high rates of unemployment include the following: • • • • • •

Black workers Hispanics Native Americans Teenagers Older workers High school dropouts

Black Workers Although black workers have made substantial economic gains over time, the unemployment rate is significantly higher for black workers than for white workers. In August 2011, the unemployment rate for blacks was 16.7 percent, while for whites it was 8.0 percent.9

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A major reason for the high unemployment rates is that many blacks work in low-skilled and low-paying occupations as laborers, in semi-skilled production jobs, or in service jobs where higher unemployment rates often prevail. In addition, blacks have higher high school dropout rates and are therefore more often inadequately educated. Inner-city schools tend to be overcrowded and facilities may be inadequate. In the critical skills of verbal and reading ability, blacks often lag behind whites. The result is that relatively more black students drop out of school. In addition, black female teenagers as a group have high out-of-wedlock birth rates, which causes many unmarried teenage mothers to drop out of school. Since high school dropouts generally lack the skills to enter the normal job market, they are forced into the lower-paying, low-status, unskilled occupations, where higher unemployment typically prevails. Finally, some blacks may be blocked from higher paying jobs because of racial discrimination and discriminatory hiring practices.

Hispanics Hispanic workers are persons of Spanish origin, including Mexican Americans, Puerto Ricans, Cubans, South Americans, and others. Hispanic workers also have relatively higher unemployment rates. In August 2011, the unemployment rate for worker with Hispanic or Latino ethnicity was 11.3 percent.10 Hispanic workers have high unemployment rates because of language barriers, inadequate education and work skills, and racial discrimination. Many are undocumented immigrants and are employed in low-status, low-paying jobs as laborers, service workers or domestics, or in semi-skilled positions. The educational system in the United States generally is oriented toward the culture of middle-class white society, as opposed to the distinct culture of Hispanic workers. Their inferior education is due in part to language and reading problems. When Spanish is the major language spoken in the home, a student is often handicapped in mastering the English language. As a result, Hispanic students may perform poorly in school and drop out, which often results in considerable poverty, unemployment, and underemployment.

Native Americans Native Americans are probably the most disadvantaged minority group in the nation. Many Native Americans suffer from alcohol and drug addiction, have health problems, are poorly educated, and often have limited marketable skills. As a result, they earn relatively low incomes and experience extremely high unemployment and underemployment rates. The unemployment rate on reservations is monumentally high. A January 2010 hearing by the Committee on Indian Affairs revealed that the national average unemployment rate in Native American communities was 50 percent, substantially above the national unemployment rate of about 10 percent at that time. In the Northern Great Plains, it was 77 percent.11 In addition, housing on most Indian reservations is generally substandard and inadequate.

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Reducing unemployment on Native American reservations is a difficult task. Many reservations are remote from industrial areas where jobs are more easily available; traditional Native American culture is not intrinsically job oriented; the financial assistance provided Native Americans in the past generally has been inadequate for overcoming the serious problems they face; and alcoholism and drug addiction on reservations are widespread. Many Native Americans migrate from the reservations into cities, but often face similar problems of poor housing, inadequate schools, inadequate marketable work skills, and high unemployment and underemployment rates. The nature of life on the reservation generally does not prepare them to be easily assimilated into city living. Consequently, high unemployment and underemployment rates cause many Native Americans to become disillusioned with city life and subsequently return to their reservations.

Teenagers Teenagers also experience high unemployment. In August 2011, the unemployment rate for teenagers 16 to 19 years was 25.4 percent.12 Several factors help to explain the relatively high unemployment rates for teenagers. First, the federal minimum wage of $7.25 can discourage employers from hiring teenagers, since it often exceeds a teenager’s marginal revenue product. The marginal revenue product is the change in the firm’s total revenue that results from the change in the input of labor by one unit. Stated differently, the additional revenue that a firm receives by hiring one additional teenager may be less than the federal minimum wage that must be paid. Second, older teenagers may go to college or other educational institutions and are frequently entering and leaving the labor force and are unemployed in the interim. Third, state child labor laws may restrict job opportunities for some young people. Finally, many teenagers are unemployed because they consider the available jobs to be low paying and unattractive. Teenagers who work in positions viewed as dead-end, low-paying jobs do not hesitate to quit, since comparable jobs may be more readily available, and unemployment during the interim period is the result.

Older Workers Older workers, those over age 55, often experience great difficulty in finding new jobs once they become unemployed. Seniority rights tend to protect the jobs of older workers, but once they lose their jobs, they are likely to remain unemployed for longer periods than younger workers. Although the unemployment rate for older workers is relatively low, the duration of unemployment is considerably longer. In August 2011, the median duration for all unemployed workers was 20.6 weeks. However, for unemployed workers ages 55 to 64, the median duration of unemployment was 30.8 weeks.13 Older unemployed workers often have a longer duration of unemployment for several reasons. First, older workers who lose their jobs because of technological

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change often have work skills that are obsolete and not readily transferable, which makes it difficult for them to find new jobs. Also, many older workers lose their jobs because of a permanent reduction in the firm’s labor force. Comparable jobs in the community may be in short supply. Second, older workers generally are reluctant to relocate geographically. Employment opportunities can be limited in a local community. Yet many older displaced workers who have homes and friends in a community find it extremely painful to relocate because of ties. In many cases, older workers take early retirement instead of accepting unemployment or sporadic employment at low wages; some are discouraged in their attempts to find new jobs and voluntarily withdraw from the labor force; others are in poor health or are disabled, which makes it difficult to maintain a full-time attachment to the work force. Finally, age discrimination by some employers and the reluctance of many firms to hire older workers are additional employment barriers.

High School Dropouts High school dropouts as a group have a substantially higher unemployment rate than the overall population. In August 2011, the unemployment rate of the civilian population age 25 and over, by educational attainment, was 14.3 percent for unemployed workers without a high school diploma. In contrast, for high school graduates with no college, the unemployment rate was 9.6 percent, and for those with a bachelor’s degree and higher, 4.3 percent.14 High school dropouts generally lack the skills needed to compete effectively for higher paying jobs in the local or national labor markets. As a result, high school dropouts are forced into the lower-paying, low-status, unskilled occupations, where higher unemployment rates typically prevail.

Current Approaches for Reducing Unemployment Under the Employment Act of 1946, the federal government must promote maximum employment opportunities for people for who want work. Specific approaches for reducing unemployment or for assisting unemployed workers include the following: • • • • • •

Monetary policy Discretionary fiscal policy Unemployment compensation benefits Improved labor market information Employment and training programs Tax credits

Monetary Policy Monetary policy is a major tool for reducing the high level of unemployment in the United States at the present time. Monetary policy refers to actions taken by the ­Federal

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Reserve that affect the money supply and interest rates to promote stable prices, full employment, and economic growth. To reduce unemployment, appropriate monetary policies must be undertaken that expand aggregate demand and total spending in the economy. An expansion of aggregate demand increases the number of jobs; promotes the success of employment and training programs because sufficient jobs may not be available at the end of training if the economy is in recession; and may eventually result in tighter labor markets, which improve the employment opportunities for workers employed part-time for economic reasons. An expansion of aggregate demand and tight labor markets also increases the wages of the working poor, making it possible for them to work their way out of poverty. The Federal Reserve has three major tools that influence the money supply, which in turn has a significant impact on economic activity and aggregate demand: (1) open market operations, (2) changes in the discount rate, and (3) changes in required reserves. The open market operations refer to the purchase and sale of government securities in the open market. The discount rate is the rate that commercial banks and thrift institutions pay the Federal Reserve for short-term loans. Required reserves refers to the funds that a commercial bank or thrift institution must deposit with the Federal Reserve or hold as vault cash, which is based on a percentage of its demand deposits. In a typical recession, traditional understanding of monetary policy states that the Federal Reserve should follow an expansionary monetary policy by purchasing government bonds in the open market, reducing the discount rate, and reducing the legal reserve requirements if necessary. These policies tend to expand the money supply and reduce interest rates and increase aggregate demand. However, the severe downswing in the United States in 2008 and 2009 was not a typical recession. Instead, the United States was on the brink of a major depression. The financial meltdown and a brutal stock market crash substantially reduced the life savings of most Americans; the subprime housing market collapsed; numerous commercial banks and financial institutions failed, and credit became scarce; the sale of unregulated derivatives, including credit-default swaps, resulted in billions of dollars of losses for investment banks and commercial banks; and regulation of the financial services industry was horribly broken and inadequate. Fear and panic were widespread, and the economy and entire banking system came terrifyingly close to a cataclysmic collapse.

Extraordinary Measures by the Federal Reserve During the economic freefall in 2008 and 2009, the Federal Reserve intervened and implemented a series of extraordinary measures to stabilize the financial markets and rescue the nation from its second worst economic downswing since the Great Depression. The Federal Reserve sold government securities on a massive scale, which reduced in a series of steps the federal funds target rate to almost zero percent. The federal funds rate is the rate that banks, which need additional reserves, must pay to borrow from other banks with excess reserves on an overnight basis. The discount rate was also reduced in a series of steps. In addition, the Federal Reserve created a

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number of targeted credit programs to increase the liquidity in the banking system and restore public confidence in the financial sector. These programs included the following:15 • Because of the collapse of the housing market, the Federal Reserve purchased mortgage-backed securities and medium- and long-term U.S. Treasury securities in the open market. These purchases placed downward pressure on interest rates in the mortgage and debt markets and helped stimulate the depressed housing market. • Lending to depository institutions was expanded, such as commercial banks and savings and loan institutions, whose liabilities consisted largely of checking and savings accounts and other deposits. • New lending programs (called facilities) were created for nondepository financial institutions and other participants in the financial markets. • Financial help was provided to commercial banks and other financial institutions considered “too big to fail” because policymakers believed that failure could lead to a systemic collapse of the financial markets and institutions.

Limitations of Monetary Policy Although monetary policy is an important tool for stabilizing the economy and reducing unemployment, it has a number of limitations. They include the following: • Monetary policy is subject to time lags. Monetary policy is a tool that cannot be applied with precision because of time lags. The need for a change in monetary policy is recognized only after a time lag. In addition, there is often a long time lag between a change in policy and its impact on the economy. It is estimated that major effects on output and employment can range from three months to two years. If the change in policy is aimed at reducing inflation, the time lag is even longer and may range from one to three years, or even longer. • The effects on the economy are not uniform. Some groups and industries may benefit from the policy change, while other groups may be affected more severely. For example, the decision by the Federal Reserve to reduce interest rates during the 2008 and 2009 recession resulted in lower mortgage interest rates and benefited potential homeowners and the housing market because of lower monthly payments. Purchasers of automobiles also benefited because of lower monthly payments. However, the interest rate reduction significantly reduced the investment incomes of older retired persons who relied on interest income for a significant part of their total income. Likewise, lower interest rates increased the funding requirements for qualified defined-benefit pension plans because interest yields on the fixed income portion of the pension portfolio were lower.

Discretionary Fiscal Policy Discretionary fiscal policy is another important tool for expanding aggregate demand and reducing unemployment. Discretionary fiscal policy refers to deliberate congres-

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sional action to change the taxing, spending, and borrowing policies of the federal government to attain full employment, economic growth, and a noninflationary level of output. Congress has enacted numerous programs over the years to stimulate the economy and reduce unemployment. The most recent was the enactment of a comprehensive fiscal stimulus package to expand economic output and reduce unemployment: the American Recovery and Reinvestment Act of 2009 (ARRA, or Recovery Act) was passed by Congress in February 2009. Congress initially appropriated $787 billion to meet three immediate goals: (1) create new jobs and save existing jobs, (2) stimulate economic activity and invest in long-term growth, and (3) promote accountability and transparency in government spending. To meet these goals, the federal stimulus package provided tax cuts and benefits for millions of working families and business firms; increased federal spending on education, health care, and entitlement programs (such as extended unemployment benefits); and made additional amounts available for federal contracts, grants, and loans. The stimulus package also required recipients of the funds to report quarterly on how the money is used. Recovery.gov is the official U.S. government Web site that provides easy access to data related to the spending of the funds and also allows individuals to report potential fraud, waste, and abuse. The intent here is to increase accountability and transparency in government spending. In addition, the stimulus package provided financial aid directly to local school districts; expanded the child tax credit; provided for a process to computerize health records to reduce medical errors and heath-care costs; provided funds for infrastructure development and enhancement, construction of roads and bridges, and investments in the domestic renewable energy industry; and provided funding for the weatherizing of 75 percent of federal buildings and more than one million private homes. Although critics argue that the Recovery Act was poorly designed and did not create jobs, research studies indicate that the fiscal stimulus package appears to be working toward reducing unemployment and expanding economic output. According to the Congressional Budget Office (CBO), the nonpartisan scorekeeper in Congress, the stimulus package had the following economic effects for the second quarter of calendar 2011:16 • Increased the real (inflation-adjusted) gross domestic product (GDP) by between 0.81 percent and 2.5 percent. • Reduced the unemployment rate by between 0.5 percentage points and 1.6 percentage points. • Increased the number of people employed by between 1 million and 2.9 ­million. • Increased the number of full-time equivalent jobs by 1.4 million to 4.0 million compared with the number of jobs that would have otherwise occurred.

Limitations of Discretionary Fiscal Policy Although discretionary fiscal policy is necessary to increase spending, expand output, and reduce widespread unemployment, it has serious limitations as a stabilizing tool.

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They include the following: • Changes in discretionary fiscal policy have a lengthy time lag. Like monetary policy, changes in taxation and spending by the federal government to stimulate the economy require deliberate congressional action, which may take months or even years to accomplish. Congressional hearings on proposed legislation may take months; congressional debate after a bill is introduced takes up additional time; a filibuster in the Senate can delay or even block passage of the bill; and powerful lobbyists who represent special interests may succeed in delaying or blocking the bill, or in having changes inserted that may dilute its effectiveness. Moreover, even if a bill is enacted into law, it can take one or more years before the full impact on the economy is known. • There may be a crowding-out effect. Borrowing by the federal government to finance a deficit from an expansionary fiscal policy can result in a crowding-out effect. This means that the federal government is competing with private borrowers for the available funds in the capital markets, which increases interest rates and “crowds out” or reduces spending on private economic investments. As a result, the stimulus from an expansionary fiscal policy may be weakened. • Spending cutbacks by state and local governments can reduce the effectiveness of an expansionary fiscal policy. Unlike the federal government, states and local governments typically operate on balanced budgets and do not go into debt on a permanent basis to meet their financial needs. During the severe 2007–2009 recession, tax revenues to most state and local governments declined significantly. State and local governments responded to the reduction in revenues by making sizable cuts in total spending, laying off thousands of workers, imposing a hiring freeze, and increasing taxes and fees. These policy actions at the state and local level, in order to attain a balanced budget, significantly diminished the effectiveness of federal fiscal policy in reducing unemployment during this period. • Political considerations and ideological beliefs held by politicians may delay or block needed change in discretionary fiscal policy. Discretionary fiscal policy used to stimulate the economy and reduce unemployment requires members of Congress to vote for specific legislation. Most members of Congress are not economists, and there is often a serious conflict between good economics and the political and ideological views held by members of Congress. As such, needed legislation to stimulate the economy may be delayed or blocked completely. For example, despite the financial meltdown and severe economic downswing in 2008 and 2009, as well as historically high unemployment rates, more than 40 percent of Congress voted against enactment of the 2009 stimulus package. This opposition was based largely on political considerations and ideological beliefs. The ideological beliefs centered on the following: (1) the federal government is too large and must be reduced in size; (2) increased government spending does not stimulate the economy and cannot significantly reduce unemployment; (3) reducing government spending and the size of the federal deficit will create numerous private-sector jobs; (4) increased borrowing from foreign nations to finance the large federal deficit, especially increased borrowing from China, is viewed as

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politically undesirable; and (5) the increased financial burden of a higher national debt on future generations of children and grandchildren is undesirable. As such, the ideological beliefs of members of Congress can delay or completely block needed legislation to increase government spending to stimulate the economy and reduce unemployment.

Unemployment Compensation Benefits Unemployment compensation benefits are a primary tool for reducing economic insecurity for workers who are involuntarily unemployed. All states have unemployment compensation programs that typically pay regular weekly cash benefits to eligible workers for up to 26 weeks. The majority of states pay weekly benefits that replace roughly one-third up to one-half of the worker’s average weekly wage during his or her base period. There is also an extended-benefits (EB) program that pays additional benefits to unemployed workers who have exhausted their regular benefits in states with high unemployment. In addition, on numerous occasions Congress has enacted temporary emergency legislation that provided additional weeks of benefits to unemployed workers who have exhausted their benefits. Finally, certain unemployment compensation programs are designed specifically for special groups, including unemployment compensation for federal employees, unemployment compensation for ex-service members, disaster unemployment assistance, trade readjustment allowances, and assistance to the self-employed. Unemployment compensation programs merit additional discussion in view of their current importance in providing a base of income to millions of unemployed workers who otherwise would be exposed to severe economic insecurity. Unemployment compensation programs, problems, and issues are discussed in greater detail in Chapters 14 and 15.

Improved Labor Market Services The U.S. Department of Labor has substantially upgraded and improved the labor services provided to job seekers, unemployed persons, and business firms with job openings. The department sponsors a one-stop services delivery system in each state that provides comprehensive labor services to job seekers, unemployment compensation claimants, and business firms at at easy-to-find locations. Specific labor services include job referral, placement assistance, reemployment services for unemployment compensation claimants, and recruitment services to employers with job openings. Other services include assessment of the skill levels, abilities, and aptitudes of workers; counseling and career advice; information on writing resumes and job interviews; job search workshops; and referral to education and training programs. Labor services are also offered to employers. Specific services include matching job seekers with job requirements and skills, development of job-order requirements, arranging for job fairs, assisting employers with hard-to-fill job orders, assisting employers with the restructuring of jobs, and help with layoffs. Veterans seeking jobs receive priority in job referrals and training programs; spe-

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cial employment services and assistance are also available. Finally, the Department of Labor provides specialized services to disabled individuals, migrant and seasonal farm workers, ex-offenders, youths, minority workers, and older workers. The enhanced labor services improve the overall quality of the labor force; labor as a scarce economic resource is used more efficiently; the labor services offered tend to reduce unemployment and underemployment; and frictional unemployment is reduced by improved information on available jobs.

Employment and Training Programs Although monetary and fiscal policy can expand aggregate demand and increase economic growth, all groups do not share equally from that growth. Employment and training programs are also necessary for assisting the structurally unemployed. The fundamental objective of employment and training programs is to increase the employability of workers by providing them with basic and vocational education skills and with on-the-job training. Many workers are unemployed today because they lack marketable job skills; lack basic education and are high school dropouts; lack information on available jobs in the community; have social, mental, or physical problems that reduce employment opportunities; are addicted to drugs or alcohol, or cannot work because of lack of transportation or child-care facilities. Employment and training programs attempt to reduce or eliminate these employment barriers. Although employment and training programs can improve the job skills and employment opportunities for structurally unemployed workers, the programs have limitations in their ability to reduce total unemployment in the United States. The programs are expensive and slow, and cannot quickly reduce total unemployment in a relatively short period; the impact on the reduction of the total unemployment in the nation is slight; jobs might not be available at the end of training, especially if the economy is in recession; and there is often considerable overlap, expensive duplication, and fragmentation of programs. A recent U.S. Government Accountability (GAO) study highlights the magnitude of the duplication problem. Of some 47 federal employment and training programs, GAO identified 44 programs that overlapped with at least one other program by providing at least one similar service to a similar population.17 The overlapping programs served multiple population groups, including Native Americans, veterans, and youths.

Federal Tax Credits to Employers To encourage the hiring of unemployed and disadvantaged workers, Congress has enacted various programs over the years that provide federal tax credits to eligible employers. A tax credit is more valuable than a tax deduction because a tax credit reduces dollar-for-dollar the federal income tax that employers must otherwise pay. A tax deduction, on the other hand, reduces the taxes paid based on the marginal tax rate of the taxpayer, which is considerably lower. For example, a tax credit of $1,000 reduces the federal income tax of an employer by $1,000; in contrast, for employers in the 28 percent income tax bracket, taxes are reduced only by $280.

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Work Opportunity Tax Credits

Tax credits encourage employers to recruit and hire disadvantaged workers by subsidizing the real or perceived costs of hiring such workers. Work Opportunity Tax Credits (WOTC) are available to employers who hire certain categories of disadvantaged workers. The 2009 Recovery Act extended the WOTC program to include additional target groups. Target groups included the following: (1) long-term recipients under the Temporary Assistance for Needy Families (TANF) program; (2) other TANF recipients; (3) certain qualified veterans; (4) qualified food stamp recipients, ages 18 to 39; (5) designated community residents, ages 18 to 39; (6) qualified summer youth employees; (7) vocational rehabilitation referrals; (8) ex-felons; (9) qualified Supplemental Security Income (SSI) recipients; (10) employees affected by Hurricane Katrina; (11) certain unemployed veterans hired after 2008 and before 2011; and (12) disconnected youths. There are various tax credits under the program. They include up to $2,400 generally for each new adult hired; $1,200 for each summer youth hired; $4,800 for each new person with a disability hired; and $9,000 for each new long-term TANF recipient hired over a two-year period. Advantages and Disadvantages of Tax Credits

The major advantage of tax credits is that employers have a strong financial incentive to hire those unemployed workers most in need of help. Tax credits are also helpful in reducing structural unemployment. On the negative side, however, tax credits have certain disadvantages. Tax credits are expensive because of reduced tax revenues to the federal government, which makes it more difficult to reduce the sizable federal deficit. In addition, tax credits alone cannot substantially reduce the total unemployment rate during economic downswings. Expansionary monetary and fiscal policies are also needed to stimulate the economy during such periods.

Summary • Involuntary unemployment can cause economic insecurity because of the loss of earned income; unemployment also forces many employees to work part-time because of economic reasons; there is also uncertainty of income for workers with jobs; and some groups have considerable difficulty finding jobs. • Cyclical unemployment (also called demand-deficient unemployment) is unemployment that results from a deficiency in aggregate demand. • Technological unemployment is unemployment that results from the displacement of workers by new computer technology, labor-saving machinery, new production techniques, or new management methods. • Structural unemployment can be defined as unemployment that results from a

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mismatch between the skills required for the available jobs in the community and skills possessed by workers seeking work. • Frictional unemployment refers to temporary unemployment that can result from the changing of jobs. • Seasonal unemployment can result from fluctuations in business activity because of weather, customs, styles, and habits. • The Bureau of Labor Statistics (BLS) releases monthly statistics on employment, unemployment, people outside the labor force, and other personal and occupational characteristics of the working population. • The unemployment rate is the number of unemployed as a percentage of the civilian labor force; the labor force comprises all persons classified as employed or unemployed in the civilian noninstitutional population age 16 and over. • Widespread unemployment has certain economic costs: loss of the GDP that could have been produced; loss of millions of years of labor; and retardation of economic growth. Noneconomic costs include deterioration in work skills, lower self-esteem, and deterioration of family life. • The underemployed include workers employed below their actual or potential skill level, people outside the labor force seeking work, and involuntary part-time workers. • Groups with high unemployment rates, as of 2011, include blacks, Hispanics, Native Americans, teenagers, older workers, and high school dropouts. • Approaches for reducing unemployment include expansionary monetary and fiscal policy, unemployment compensation benefits, improved labor market information, employment and training programs, and federal tax credits to employers. • Monetary and fiscal policies have limitations in reducing unemployment. Monetary policy is subject to time lags, and the effects on the economy are not uniform. Changes in discretionary fiscal policy also have a lengthy time lag; there may be a crowding-out effect; spending cutbacks by state and local government can reduce the effectiveness of expansionary fiscal policy; and political considerations and ideological beliefs of politicians can delay or block needed legislation.

Review Questions 1. Explain how unemployment can cause economic insecurity. 2. Briefly explain the major types of unemployment in the United States. 3. Briefly explain how the national unemployment rate is determined. 4. What are the limitations of the total unemployment rate as a tool for measuring unemployment and labor market conditions? 5. Identity the groups that are currently experiencing relatively high unemployment rates. 6. Explain the meaning of underemployment of human resources. 7. Explain how monetary policy and discretionary fiscal policy can reduce unemployment during recessions and periods of slow economic growth.

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8. Explain the limitations of monetary policy in reducing unemployment. What are the limitations of discretionary fiscal policy in reducing ­unemployment? 9. What are the limitations of training and education programs in reducing unemployment? 10. Explain how federal tax credits can reduce unemployment for certain groups.

Application Questions 1. The Bureau of Labor Statistics provides detailed information on unemployment at the national, state, and local level. Go to www.bls.gov/lau/home.htm. See “Latest Numbers” and answer the following questions: a. What is the latest unemployment rate in the state where you are now residing? b. For the state selected in (a) above, what has been the trend in the unemployment rate for the past 10 years? (Click on the icon opposite the state that you selected in (a) above.) 2. Kelly, age 35, spends most of her time at home taking care of her home and children. However, she works all day Friday and Saturday in her husband’s computer store. She receives no compensation for her work. Would Kelly be counted as employed or unemployed in the monthly labor force statistics? Explain your answer. 3. James, age 28, was laid off by an auto manufacturer when the firm began retooling to produce a new model car. He knows he will be called back to work when the model changeover is completed. Although he is available for work, he is not seeking a job. Would James be counted as employed or unemployed in the monthly labor force statistics? Explain your answer. 4. Courtney, age 22, is a junior at a large midwestern university. In late March, she filed applications for summer jobs with three companies. However, she does not want to start work until June 15 after the spring semester is completed. Would Courtney be classified as employed, unemployed, or not in the labor force in the monthly labor force statistics? Explain your answer.

Internet Resources • The Center on Budget and Policy Priorities provides considerable information on the effectiveness of state and federal legislation dealing with tax policies, job creation, recessions and recovery, unemployment compensation, and other areas that affect jobs and economic security. Visit the site at www.cbpp.org • The Bureau of Economic Analysis (BEA) in the Department of Commerce is one of the world’s leading statistical agencies. BEA produces closely watched economic statistics that enable policymakers, researchers, government officials, and the public to follow and understand the U.S. economy. Visit this important site at www.bea.gov • The Bureau of Labor Statistics in the U.S. Department of Labor is the primary

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source of statistics on unemployment and employment at the national, state, and local levels. The site provides detailed information on unemployment by age, gender, race, occupation, income, education, and other characteristics. Visit this comprehensive site at www.bls.gov • Employment and Earnings Online is a monthly online publication by the Bureau of Labor Statistics. The publication provides detailed information on employment, unemployment, earnings by occupation, benefits, productivity, workplace injuries, and other information about the labor force. Visit the site at www.bls.gov/opub/ee/home.htm • The Economic Report of the President is an annual report written by the chairman of the Council of Economic Advisers. It provides an overview and analysis of the nation’s economic progress using the report and extensive statistics in the appendices. Visit the site at www.gpoaccess.gov/eop • The W.E. Upjohn Institute for Employment Research conducts research into the causes and effects of unemployment and measures for the alleviation of unemployment. The institute analyzes the dynamics of labor markets and evaluates employment programs around the world. Visit its site at www.upjohninst.org

Selected References Congressional Budget Office. “The Budgetary Impact and Subsidy Costs of the Federal Reserve’s Actions During the Financial Crisis.” Washington, DC, May 2010. ———. “Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from April 2010 through June 2010.” Washington, DC, August 2010. ———. Information on Reducing Payroll Taxes to Encourage Employment. Letter to Honorable Robert P. Casey, Jr. from Douglas W. Elmendorf, Director, February 3, 2010. ———. “Policies for Increasing Economic Growth and Employment in the Short Term.” Statement of Douglas W. Elmendorf, Director, prepared for the Joint Economic Committee, U.S. Congress, February 23, 2010. Johnson, Richard W., and Corina Mommaerts. How Did Older Workers Fare in 2009? Washington, DC: The Urban Institute, March 2010. McConnell, Campbell R., Stanley L. Brue, and David A. Macpherson. Contemporary Labor Economics. 9th ed. New York: McGraw-Hill Higher Education, 2010. U.S. Department of Labor. Bureau of Labor Statistics. “Employment and Earnings Online.” Available at www.bls.gov/opub/ee/home.htm U.S. Government Accountability Office. “Opportunities to Reduce Potential Duplication in Government Programs, Save Tax Dollars, and Enhance Revenue.” GAO-11-318SP, March 2011. Wander, Stephen A. “Employment Programs for Recipients of Unemployment Insurance.” Monthly Labor Review (October 2009): 17–27.

Notes 1. Bureau of Labor Statistics, “Employment Situation Summary.” News release, September 2, 2011, Table A-1 and Table A-15. 2. This section is based on Bureau of Labor Statistics, “How the Government Measures Unemployment.” Available at www.bls.gov/cps/cps_htgm.htm 3. Bureau of Labor Statistics, “Employment Situation Summary,” Table A-15.

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4. Ibid., Summary Table A. 5. Ibid., Table A-11. 6. Ibid., Table A-12. 7. Bureau of Labor Statistics, “Metropolitan Area Employment and Unemployment—July 2011.” News release, August 31, 2011, Table 1. Data are not seasonally adjusted. 8. Bureau of Labor Statistics, “Employment Situation Summary,” Table A-8. 9. Ibid., Summary Table A. 10. Ibid. 11. Committee on Indian Affairs, Unemployment on Indian Reservations at 50 Percent: The Urgent Need to Create Jobs in Indian Country. Hearing before the Committee on Indian Affairs, United States Senate, One Hundred Eleventh Congress, Second Session (Washington, DC: U.S. Government Printing Office, January 28, 2010), p. 1. 12. Bureau of Labor Statistics, “Employment Situation Summary,” Summary Table A. 13. Bureau of Labor Statistics, “Employment and Earnings Online.” News release, August 2011, Table A-36. The data are not seasonally adjusted. 14. Bureau of Labor Statistics, “Employment Situation Summary,” Summary Table A. 15. Congressional Budget Office, “The Budgetary Impact and Subsidy Costs of the Federal Reserve’s Actions During the Financial Crisis” (Washington, DC: Congressional Budget Office, May 2010) pp. 2–3. 16. Congressional Budget Office, “Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from April 2011 Through June 2011” (Washington, DC: Congressional Budget Office, August 2011), pp. 2–3. 17. U.S. Government Accountability Office, “Opportunities to Reduce Potential Duplication in Government Programs, Save Tax Dollars, and Enhance Revenue.” GAO-11318SP, March 2011, p. 140.

14 Unemployment Compensation

Student Learning Objectives After studying this chapter you should be able to: • Explain the basic objectives of unemployment compensation. • Explain the eligibility requirements that must be met to receive weekly unemployment compensation benefits. • Understand the major provisions of unemployment compensation laws, ­including: – Coverage – Benefit amounts – Qualifying wages – Duration of benefits • Identify the major situations that can disqualify unemployed workers from ­receiving benefits. • Describe the permanent extended-benefits (EB) unemployment insurance ­program. • Explain how state unemployment compensation programs are financed. • Explain the major arguments for and against experience rating in the financing of benefits. • Describe the basic features of temporary disability insurance laws that exist in five states and Puerto Rico. Unemployment compensation is a federal-state program that provides for the partial replacement of income during periods of short-term involuntary unemployment. All states pay benefits to temporarily unemployed workers in covered employment who are currently attached to the labor force and fulfill certain eligibility requirements. The benefits paid bolster consumption, add to purchasing power, and help cushion the negative economic impact of unemployment in communities with high unemployment rates. The unemployment compensation system in the United States consists of several 313

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distinct programs: a regular state unemployment compensation program in all states as well as the District of Columbia, Puerto Rico, and the Virgin Islands; a federalstate program of permanent extended benefits, which pays additional benefits during periods of high unemployment; a permanent unemployment compensation program for ex-service members; a program for federal civilian employees; and the Railroad Unemployment Insurance Act for railroad workers. In this chapter, we examine the major provisions of regular state unemployment compensation programs. Federal unemployment compensation programs for federal civilian employees, ex-service members, and railroad workers are discussed in Chapter 17. More specifically, topics discussed in this chapter include the development of unemployment compensation in the United States, objectives of unemployment compensation, major provisions of state unemployment compensation laws, extended unemployment benefits, and the financing and administration of unemployment compensation programs. The chapter concludes with a discussion of compulsory temporary disability insurance laws, which complement the unemployment compensation programs in six jurisdictions and the railroad industry.

Development of Unemployment Compensation Unemployment compensation in the United States was enacted into law in August 1935 as part of the original Social Security Act of 1935. Prior to that time, only limited assistance was available to unemployed workers.1 Some states had previously established work relief programs that provided some assistance to the poor; however, recipients were required to work or perform other public services in return for the aid. Private charities provided some assistance, but their limited financial resources precluded payment of unemployment benefits for extended periods. Some labor unions also provided temporary assistance, but to relatively few recipients. A few firms had established private unemployment plans, but financing problems and massive unemployment during the Depression of the 1930s made it difficult to provide extensive aid. Finally, a few states, including Wisconsin in 1932, considered or enacted unemployment compensation legislation. The Wisconsin law later served as the basis of the unemployment insurance provisions of the Social Security Act of 1935. The Social Security Act also established a federal-state system of unemployment compensation, rather than one completely administered by the federal government, because of fear that a federal program alone would be unconstitutional. Also, because of disagreement concerning benefits, financing, administration, and other areas, it was believed that each state was best suited to develop its own unemployment compensation program, and that state administration was more feasible than federal administration. Each state was free to develop its own program, subject to certain federal minimum standards. The Social Security Act of 1935 encouraged the states to enact these programs by the use of a tax offset. A federal uniform tax was levied on the payrolls of covered employers who employed 8 or more workers for 20 or more weeks in a calendar year. If the state had an acceptable unemployment insurance program, 90 percent of the employers’ tax could be deducted or offset and used by the state to meet its own

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unemployment problems instead of going to the federal government. The remaining 10 percent of the tax was paid to the federal government for administrative expenses incurred by both the federal government and state unemployment compensation systems. Employers in states without unemployment insurance laws would not have a competitive advantage over those in other states, because they would still have to pay the federal payroll tax. However, their employees would he ineligible for unemployment compensation benefits. Thus, the states had a strong financial incentive to enact acceptable unemployment compensation laws, and by 1937, all states had done so. The original tax in 1936 was 1 percent on the entire payroll of covered employers, 2 percent in 1937, and 3 percent in 1938. In 1939, an amendment limited the payroll tax to 3 percent of the first $3,000 per year for each covered worker. Since that time, the federal tax rate and taxable wage base have been increased several times. As of July 1, 2011, the federal payroll tax is 6.0 percent of the first $7,000 paid to each covered employee. However, if the state meets certain federal requirements, covered employers can receive a maximum tax credit of 5.4 percent of taxable wages. The remaining 0.6 percent is paid to the federal government and is used for administrative expenses; for financing the federal government’s share of the extended-benefits program for maintaining a loan fund from which states can temporarily borrow when their accounts are depleted; and for benefits under certain federal supplemental and emergency programs. Each state must meet certain federal minimum standards if covered employers are to receive a tax offset against the federal tax and if the state is to continue receiving federal grants for administration. They include the following:2 • Compensation must be paid through public employment offices or other approved agencies. • All funds collected under the state program are deposited in the federal Unemployment Trust Fund. • All money withdrawn from the state trust fund account is used to pay compensation, to refund amounts erroneously paid into the fund, or used for other specified activities. • Compensation cannot be denied to anyone who refuses to accept work because the job is vacant as the direct result of a labor dispute, or because wages, hours, or conditions of work are substandard, or, as a condition of employment, the individual must join a company union or resign from or refrain from joining any legitimate labor organization. • Compensation can be paid to eligible employees of state and local governments and Indian tribes. • Compensation can be paid to employees of nonprofit organizations that are tax-exempt under the Federal Unemployment Tax Act (FUTA), including schools and colleges, and that employ 4 or more workers in each of 20 weeks in the calendar year. • Payment of compensation benefits to certain employees of educational institutions operated by state and local governments, nonprofit organizations, and Indian tribes is limited during periods between and within academic terms. • State and local governments, nonprofit organizations, and Indian tribes can elect

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to pay regular employer contributions or finance benefit costs by the reimbursement method. • Compensation cannot be paid in two successive benefit years to an individual who has not worked after the beginning of the first benefit year. • Compensation cannot be denied to anyone solely because the individual is taking part in an approved training program. • Compensation cannot be denied by reason of cancellation of wage credits or total benefit rights for any cause other than discharge for work-connected misconduct, fraud, or receipt of disqualifying income. • Compensation cannot be denied or reduced because an individual’s claim for benefits was filed in another state or in Canada, and the state participates in arrangements for combining wages earned in more than one state for eligibility and benefit purposes. • Compensation cannot be denied solely on the basis of pregnancy or termination of pregnancy. • Compensation cannot be paid to a professional athlete, between seasons, who has a reasonable assurance of resuming employment when the new season begins. • Under certain conditions, the benefit amount of an individual is reduced by that portion of a pension or other retirement income (including Social Security and Railroad Retirement income) that is funded by a base period employer. • Reduced tax rates for employers are permitted only on the basis of their unemployment experience.

Objectives of Unemployment Compensation Unemployment compensation programs have both primary and secondary objectives. The primary objectives involve assistance to individual workers during periods of involuntary unemployment. The secondary objectives emphasize economic stability and efficiency.3

Primary Objectives Primary objectives aim directly at providing financial help to workers during temporary periods of involuntary unemployment. They include the following: • Provide cash payments during involuntary unemployment. The most important primary objective is to provide cash payments to unemployed workers during periods of involuntary unemployment. The benefits partially replace the loss of earned income and provide a base of economic security to unemployed ­workers. • Maintain the worker’s standard of living. Unemployment compensation also has the objective of maintaining, to a substantial degree, the unemployed worker’s current standard of living. This can be achieved by providing benefits that are adequate in amount and duration. However, as discussed in Chapter 15, unemployment compensation benefits in many states are inadequate for maintaining a reasonable standard of living during a period of unemployment.

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• Provide time to find employment. Another important goal of unemployment compensation is to provide time so that unemployed workers can find employment. The benefits paid enable unemployed workers to find jobs consistent with their work skills and experience from previous employment. • Help unemployed workers find jobs. Another primary objective is to help unemployed workers find jobs. Unemployed workers apply for benefits at local employment offices and are given information on the available jobs in the community. In many cases, the workers are laid off permanently and will never be re-employed by their former employers. These permanently displaced workers can be given information about retraining programs and an upgrading of their occupational skills so that they can find new jobs.

Secondary Objectives The secondary objectives of unemployment compensation are to promote economic stability and efficiency. The broad economic goals are to stabilize the economy and to improve the utilization and allocation of labor resources. • Help stabilize the economy during recessions. Unemployment compensation helps to stabilize the economy during recessions. During economic downswings, unemployment insurance claims quickly increase, and the payment of benefits enables unemployed workers to maintain their personal income and consumption spending. As a result, unemployment compensation benefits operate in a desirable countercyclical manner. This effect takes place whether the unemployment is confined to a local area or is widespread during a national recession. • Improve the allocation of social costs of unemployment. Another objective is to improve the allocation of the social costs of unemployment by distributing these costs among the employers based on their layoff experience. If firms with high rates of layoffs are charged with the costs of unemployment benefits, these costs can be included in the costs of production, which can then be reflected in higher product prices. Resource allocation is thereby improved, to the extent that the social costs of unemployment are charged to the production of particular goods and services that give rise to them. • Promote better utilization of labor. Unemployment insurance can promote greater economic efficiency in the utilization of labor by encouraging unemployed workers to find appropriate jobs and, where necessary, helping them to improve their job skills. Certain aspects of unemployment compensation indirectly promote better labor utilization. To reduce malingering and preserve work incentives, weekly unemployment benefits generally are below prevailing wage levels. Also, unemployment insurance recipients must register for work at a public employment office, thus making possible a quicker reentry into the labor force. • Encourage employers to stabilize employment. Through the use of experience rating, unemployment compensation encourages some employers to stabilize their employment patterns. Some firms can do little to stabilize their patterns; for others, the amount of potential tax savings may be insufficient to induce them to

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reduce their unemployment. But evidence indicates that significant unemployment tax differentials exist among firms within an industry, reflecting differences in unemployment experience. Thus, some firms can reduce their unemployment taxes through more aggressive efforts to stabilize employment. • Help employers maintain a skilled work force. Unemployment compensation enables employers to maintain their skilled or experienced work force during temporary periods of unemployment. Because the benefits provide income during such periods, skilled workers are not forced to find other jobs, and they are free to return to work when they are recalled.

State Unemployment Compensation Provisions Although the states must meet the minimum federal standards described earlier, they are free to develop their own unemployment compensation programs. Each state determines coverage, eligibility requirements, and benefit amounts, and duration of benefits.4

Covered Occupations Most private firms, state and local governments, and nonprofit organizations are covered for unemployment benefits. A private firm must pay the federal unemployment tax if it employs one or more employees in each of at least 20 weeks during the current or preceding calendar year, or if it pays wages of $1,500 or more during any calendar quarter in the current or preceding calendar year. Agricultural firms are covered if they have a quarterly payroll of at least $20,000 or employ 10 or more workers for at least one day in each of 20 different weeks during the current or prior year. Domestic employment in a private household is covered if the employer pays domestic wages of $1,000 or more in any calendar quarter during the current or prior year. Nonprofit organizations of a charitable, educational, or religious nature are covered if the nonprofit employer employs four or more people for at least one day in each of 20 different weeks during the current or prior year. The nonprofit organization has the right either to reimburse the state for the benefits paid or pay the state unemployment tax under the state’s law. Many jurisdictions have extended coverage of nonprofit employees beyond that required by federal law, For example, some jurisdictions now cover nonprofit organizations that employ one or more workers (rather than four or more). Most jobs in state and local government are also covered for unemployment benefits. State and local governments are not required to pay the federal unemployment tax and have the option of reimbursing the state for any unemployment benefits paid rather than paying regular state unemployment compensation tax contributions. Finally, the states are allowed to cover certain jobs not required to be covered under federal law. However, most states have not significantly expanded their unemployment insurance laws to cover such occupations. Occupations that can be excluded include the following:

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• Self-employment • Certain agricultural labor and domestic service • Service performed for an employer by a spouse or minor child • Student nurses and interns employed by a hospital • Students working for schools • Certain immigrant farm workers • Certain seasonal camp workers • Railroad workers (covered under their own system)

Monetary Eligibility Requirements All states require covered unemployed workers to meet certain monetary requirements in order to be eligible for benefits. In addition to being involuntarily unemployed through no fault of their own, unemployed workers must typically meet the following requirement to receive benefits: • Have qualifying wages or employment • Serve a waiting period in most states • Be able to work and be available for work • Actively seek work Qualifying Wages or Employment

Unemployed workers must meet certain monetary requirements to receive benefits. This means that they must earn a specified amount of qualifying wages or work for a certain period of time (or both) during their base period to qualify for minimum and maximum weekly benefits. In most states, the base period is the first four of the last five completed calendar quarters before the unemployed person claims benefits. In addition, most states require employment in at least two calendar quarters of the base period. The purpose of the qualifying wages requirement is to limit unemployment compensation benefits to workers with a current attachment to the labor force. The states use a number of methods to determine the amount of minimum qualifying wages during the base period, as discussed below: • Multiple of high-quarter wages. Under this method, workers must earn a certain dollar amount in the quarter in which their earnings are the highest. In addition, workers must earn total base-period wages that are a multiple of their high-quarter wages, which is typically 1.5. For example, if a worker earns $5,000 in the high quarter, he or she must earn an additional $2,500 during the base period to qualify for benefits. • Multiple of weekly benefit amount. Under this method, the state first calculates the worker’s weekly benefit amount, which is then multiplied by some factor to determine the required amount of qualifying wages. A multiple of 40 is often used. For example, if the worker’s weekly benefit is $100, he or she must earn

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at least $4,000 during the base period before any benefits are paid. In addition, most states require wages in at least two quarters. • Flat qualifying amount. Under this method, workers must earn a certain amount of total wages during their base period to qualify for benefits. For example, Arkansas requires workers to earn at least $2,500 and have wages in two quarters during the base period. • Weeks or hours of employment. Under this method, workers must have worked a certain number of weeks or hours at a certain weekly or hourly wage to qualify for benefits. In 2010, qualifying wages during the base period for minimum weekly benefits ranged from $130 in Hawaii to $4,551 in North Carolina. Qualifying wages during the base period for maximum potential weekly benefits ranged from $5,320 in Puerto Rico to $41,500 in New Hampshire. The maximum potential benefit is the maximum weekly benefit amount (WBA) multiplied by the maximum potential duration of weeks of benefits. If the unemployed worker has sufficient qualifying wages and weeks of work, he or she is eligible to receive unemployment benefits during the benefit year. The benefit year is a 52-week period during which the unemployed worker can receive benefits; the benefit year usually begins on the day or the week for which the worker first files a claim for benefits. No state allows workers who receive benefits in one benefit year to qualify for benefits in a second benefit year unless the worker has earned sufficient wages after the first benefit year. The purpose of this requirement is to prevent the entitlement to benefits in two successive benefit years following a single separation from work. Waiting Period

Most states require claimants to meet a one-week waiting period before benefits are payable. Twelve states have no waiting period. Others reimburse workers for the one-week waiting period for unemployment beyond a certain number of weeks. Some states waive the waiting period under certain conditions, such as natural disasters, bankruptcy of the employer and termination of business, and major industrial disasters. A small number of states also waive the waiting period for a new or consecutive benefit year. The purposes of the waiting period are to eliminate short-term claims, hold down program costs, reduce administrative expenses, and provide time to process claims. Able to Work and Available for Work

The unemployed worker must also be both able to work and available for work. Able to work means that the claimant is capable of working; a few states specify that the claimant must be mentally and physically able to work. Available for work means that the claimant is ready, willing, and otherwise prepared to work. Claimants generally may not refuse an offer of suitable work without good cause.

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Actively Seek Work

Most states require claimants to actively seek work or make a reasonable effort to obtain work. An unemployed worker is not required to take any job. However, if a claimant refuses suitable work without good cause, he or she can be disqualified for benefits. Suitable work generally is work in a claimant’s customary occupation that meets certain health, safety, moral, and labor standards. Certain criteria are applied in determining whether a particular job is considered suitable work. Usual criteria include the degree of risk to a claimant’s health, safety, and morals; physical fitness, prior training, experience, and earnings of the claimant; the length of unemployment and prospects of finding a local job in a customary occupation; and the distance of available work from the claimant’s residence. In general, as the duration of unemployment increases, the claimant is required to accept a wider range of jobs.

Nonmonetary Eligibility Requirements All states also have nonmonetary eligibility requirements, which refer to disqualification provisions in the law. That is, some weeks of unemployment may not qualify for benefits because of certain actions by the workers who filed the claims. Disqualifying acts include voluntarily quitting work without good cause, the inability to work or unwillingness to accept full-time work, discharge for misconduct connected with work, refusal of suitable work without good cause, and unemployment resulting from a labor dispute. Disqualification provisions typically include one or more of the following: (1) postponement of benefits for a certain number of weeks, (2) postponement of benefits for the duration of unemployment until the worker again qualifies for benefits, or (3) a reduction in benefits otherwise payable. The duration of disqualification may be for a specific uniform period, for a variable period, or for the entire period of unemployment after the disqualifying act. The theory of denying benefits for a specified period is that, after a limited period, the worker’s unemployment is due to labor market conditions rather than to the disqualified act. Thus, he or she should not be punished further by a denial of benefits beyond that period. Voluntarily Quitting Work Without Good Cause

All states have disqualifying provisions that apply to workers who voluntarily quit their jobs without good cause. Benefits are not paid for a certain number of weeks. For example, Nebraska does not pay benefits for 12 weeks to workers who voluntarily quit their jobs. The meaning of “good cause” generally is restricted to reasons associated with the job, conditions at work, or involving fault on the part of the employer. The theory is that if the employer creates conditions of work that no reasonable person can tolerate, the worker’s separation is involuntary and he or she should then be compensated. However, if the worker quits for other reasons, he or she caused the unemployment and should not be eligible for benefits.

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There is wide variation among the states concerning the meaning of “good cause.” Workers who quit because of sexual harassment or other harassment at work are potentially eligible for benefits in most states. Workers who leave their jobs in anticipation of a plant closing in order to accept another job are potentially eligible for benefits in some states but not in others. Finally, workers who quit their jobs to move with a spouse who is being relocated are potentially eligible for benefits in some states. Inability to Work or Unwilling to Accept Full-Time Work

There are only minor variations among the states regarding the ability to work. Evidence of ability to work is the filing of claims and registration for work at a public employment office, which are requirements under most state laws. “Available for work” typically means the worker is ready, willing, and able to work. Meeting the requirement of registration for work at a public employment office provides some evidence of being available for work. Workers may be disqualified because they place substantial restrictions upon the types of jobs or conditions of otherwise suitable work that they will accept, by their refusal of a referral to suitable work made by the employment service, or by refusing an offer of suitable work made by an employer. Discharge for Misconduct Connected with Work

Workers can be disqualified for benefits because of disqualifying acts of misconduct. Examples of disqualifying acts include continuous absence from work without notice, violation of safety rules, assault, committing a felony in connection with work, drinking on the job and using illegal drugs, stealing from the company, or other dishonest or criminal acts. In most states, the misconduct must be willful or deliberate, and it must be in connection with the work to be disqualifying. Refusal of Suitable Work Without Good Cause

Most states have criteria to determine whether a claimant is refusing suitable work. As stated earlier, the criteria for “suitability” include the degree of risk to the worker’s health, safety, and morals; physical fitness and previous training, experience, and earnings; length of unemployment and prospects for securing local work in the worker’s usual occupation; and the distance to work from home. Workers are not required to take any job, but if they refuse to take a job considered suitable based on state law, unemployment benefits can be denied. Unemployment Resulting from a Labor Dispute

All states have restrictions on the payment of benefits to workers who are unemployed because of a labor dispute and work stoppage. Some states, however, exclude certain labor disputes from these restrictions. Some states pay benefits if the workers are unemployed because of a lockout by the employer; several states pay benefits if

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the strike results from the employer’s failure to conform to the provisions of a labor union contract or to the state’s labor laws; and most states pay benefits to workers who are unemployed because of a strike if they are not participating in the labor dispute, financing it, or who have a direct interest in it. Unemployment during a labor dispute is generally not covered because strikes and lockouts are tactics of economic warfare in which the state should remain neutral. In effect, payment of unemployment benefits to striking workers amounts to a subsidy by the state and violates that neutral position. Also, the payment of benefits means that the employers are financing the strike, since unemployment compensation taxes are paid entirely by them in most states. Finally, the denial of benefits is justified on the grounds that the workers are not involuntarily unemployed but have elected to exercise their right to strike. Other Disqualification Provisions

Depending on the state, certain groups may be ineligible for unemployment benefits. Students may be ineligible for benefits if they quit work to attend school (except training for a trade in some states). Benefits cannot be paid to elementary and high school teachers, university professors, and other professional school employees during vacation periods or between school terms (provided there is reasonable assurance of reemployment after the vacation period). Also, benefits cannot be paid to illegal immigrants or to professional athletes on the basis of employment as a professional athlete. In addition, all states have special disqualification provisions covering fraudulent misrepresentation used to obtain or increase unemployment benefits. All states also have provisions for recovering benefits paid to people who are not entitled to them. Finally, depending on the state, a certain number of weeks may be disqualified for benefits if the claimant is receiving certain types of disqualifying income, such as wages in lieu of notice, severance pay, workers’ compensation, holiday pay, or back pay.

Weekly Benefit Amounts Federal law does not establish benefit standards in the federal-state system of unemployment compensation. The weekly benefit amounts vary widely among the states, and diverse and complex formulas are used to determine benefits. The benefit amount is based on the worker’s earnings during his or her base period within certain minimum and maximum dollar amounts. Several methods are used to determine the weekly benefit amount.5 In the majority of states, the weekly benefit amount is computed as a fraction of the worker’s high-quarter wages. For example, if the fraction is 1/26, the benefit paid is equal to 50 percent of the full-time wage for workers with 13 full weeks of employment during their high quarter. For example, assume that Jane earns $400 weekly during her high quarter, totaling $5,200. Applying the fraction of 1/26 to this amount gives her a weekly benefit of $200, or 50 percent of the full-time weekly wage. Some states use a weighted schedule to provide relatively higher benefits to low-paid workers.

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Some states compute the weekly benefits as a percentage of the worker’s average weekly wage in the base period or in part of the base period. For example, the weekly benefit may be 50 to 70 percent of the worker’s average weekly wage, up to some statutory maximum. Finally, a few states compute the weekly benefit as a percentage of annual wages. Minimum and Maximum Weekly Benefits

All states have minimum and maximum statutory limits on the weekly benefit amount. In January 2010, minimum weekly benefits ranged from $5 in Hawaii to $133 in Washington. Maximum weekly benefits ranged from $235 in Mississippi to $629 ($943 with dependents) in Massachusetts. The average weekly benefit in the United States was $308 for the fourth quarter of 2009. Automatic Adjustments to Weekly Benefit Amounts

The majority of states pay unemployment benefits that are designed to replace a certain percentage of the worker’s wages up to some fixed percentage of the state’s average weekly wage. Because wages increase over time, such states periodically recalculate the average weekly wage to update the benefits schedule so that the weekly benefit amount continues to replace the desired percentage of the worker’s lost wages. In these states, the maximum weekly benefit amount is usually more than 50 percent of the state’s average weekly wage in covered employment during a recent one-year period. Dependents’ Allowances

Fourteen states and the District of Columbia pay additional unemployment benefits if eligible dependents are present. Eligible dependents typically include children under a certain age, such as under age 18, or under age 21 or 24 if a full-time student. The intent is to include all children that the worker is morally obligated to support. Also, most states with dependents’ allowances pay benefits on behalf of older children who cannot work because of physical or mental disability. In some states, nonworking spouses, parents, and siblings may also be eligible for benefits.

Duration of Benefits All states have limits on the duration of benefits. The duration is usually measured as a number of weeks of total unemployment. The maximum duration of benefits under regular state programs is 26 weeks in most states. Massachusetts pays benefits for up to 30 weeks. However, in 2011, Missouri and South Carolina reduced the maximum duration of regular state benefits to 20 weeks for newly unemployed workers, and Arkansas reduced the maximum duration for regular benefits to 25 weeks. The duration of benefits can be uniform for all claimants or variable. Eleven states

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have a uniform duration of 26 weeks for all workers who meet the qualifying-wages requirement in their base period. However, the majority of states have a variable duration of benefits, which is based on the wages earned by the individual worker during the base period. As a result, not all workers qualify for 26 weeks of benefits. For workers who fail to earn the maximum amount of wages required to receive benefits for the full 26-week period, the duration of benefits is considerably shorter. For example, for the fourth quarter of 2009—a period of high unemployment in the United States—the average duration of benefits was 18.8 weeks.5 As a result, many claimants with relatively short benefit periods exhaust their unemployment benefits and remain unemployed. As such, these claimants are exposed to considerable economic insecurity. The exhaustion of benefits is an important issue; it is discussed in greater detail in Chapter 15.

Partial Unemployment During recessions, workers may have their hours cut instead of being laid off. Other workers may be laid off but find part-time jobs. Unemployment compensation benefits can be paid to these workers if they meet all eligibility requirements. In most states, a worker is considered partially unemployed during a week of part-time work if the amount earned is less than the weekly benefit amount. Some states consider a worker to be partially unemployed if he or she earns less than the weekly benefit amount plus an allowance either from odd jobs or from any other source. The unemployment benefit paid for a week of partial unemployment is generally the difference between the weekly benefit amount and the amount earned. All states disregard a certain amount of earnings to encourage claimants to take short-term work.

Short-Time Compensation Programs Eighteen states have enacted special “short-time compensation programs” that allow employers faced with a need to lay off workers to instead reduce the hours of work and provide unemployment compensation benefits that partly offset the loss of earnings. As such, the program enables employers to retain a skilled work force during temporary layoffs, such as temporary unemployment from a model change. Workers generally must work four days a week to avoid significant wage losses. During these temporary layoffs, workers are not required to look for work or accept other jobs so that they can return promptly to their previous employer when they are recalled.

Extended Unemployment Benefits Many unemployed workers exhaust their regular unemployment benefits during periods of high unemployment. In 1970, Congress established a permanent federal-state program of extended benefits (EB) to meet the problem. When the insured unemployment rate (IUR) in a state reaches certain specified levels, the state must extend the duration of benefits normally allowed by 50 percent up to a combined total maximum of 39 weeks. The insured unemployment rate is the ratio of unemployment insurance

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claims to total employment covered by unemployment compensation programs. Under permanent law, the cost of the EB program is financed equally by the federal government and the states. However, because of the severe recession in 2008 and 2009, the federal government paid 100 percent of most EB costs for weeks of unemployment after February 17, 2009, and before April 5, 2010. Extended benefits can be paid only if the IUR in the state reaches certain specified levels. The IUR is substantially below the total unemployment rate (TUR) because some unemployed workers are excluded in the definition. The IUR excludes (1) unemployed workers who have exhausted their benefits; (2) unemployed workers who have not yet earned benefit rights, such as new entrants into the labor force or reentrants into the labor force; (3) disqualified workers whose unemployment results from their own actions rather than from economic conditions, such as workers discharged for misconduct on the job; and (4) eligible unemployed persons who do not file for benefits. Benefits are paid when the IUR in the state reaches the specified level and triggers the payment of benefits. The rules for triggering benefits are complex. There are three EB triggers. One trigger is mandatory, and the state has the option of using an additional trigger if desired. • Mandatory. A state must pay extended benefits if the IUR for the previous 13 weeks is at least 5 percent and is 120 percent of the rate for the same 13-week period in the 2 previous years. • Optional. A state has the option of paying EB for up to 13 weeks if the IUR for the previous 13 weeks is at least 6 percent regardless of its experience in previous years. • Optional. A state has the option of paying up to 13 weeks of EB if the average total unemployment rate (TUR), seasonally adjusted, for the most recent 3 months is at least 6.5 percent and is 110 percent of the rate for the corresponding 3-month period in either or both of the 2 previous years. However, if the TUR is at least 8.0 percent and is 110 percent of the rate for the corresponding 3-month period in either or both of the 2 previous years, the duration is increased from 13 to 20 weeks. In early 2010, the majority of states were using this option.

Temporary Emergency Unemployment Compensation During recessions, millions of unemployed workers exhaust their regular state benefits. In addition, many unemployed workers who exhaust their regular benefits live in states where the unemployment rate is not high enough to trigger additional weeks of benefits under the permanent EB program. To deal with the exhaustion of benefits, Congress on numerous occasions has enacted temporary emergency programs that provided additional weeks of benefits to unemployed workers. In 2008, Congress enacted the Emergency Unemployment Compensation 2008 (EUC08) program, which has been modified several times. More recently, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the EUC program to January 3, 2012.

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The above legislation is complex and beyond the scope of the text to discuss in detail. However, the actual duration of benefits will vary depending on state’s unemployment insurance law and the unemployment rate in the state. As stated earlier, most states pay regular benefits up to 26 weeks. In addition, the various extensions under the EUC program provided a maximum duration of up to 53 additional weeks of EUC benefits, depending on the state’s unemployment rate. Finally, if EB benefits were available, and depending on the state, up to 20 additional weeks of benefits could be paid to workers who exhausted both regular benefits and EUC benefits. Thus, in 2011, again depending on the state, the maximum duration of benefits from all programs was up to 99 weeks. However, as of October 11, 2011, less than half of the states provided a maximum benefit duration of 99 weeks from regular, EUC, and extended benefits.6

Unemployment Compensation for Special Groups Unemployment compensation programs in the United States also include programs designed for special groups. These programs include the following: • Disaster Unemployment Assistance (DUA). Disaster Unemployment Assistance (DUA) provides financial assistance to individuals whose employment or self-employment is lost or interrupted as a direct result of a major disaster, and the individuals are not eligible for regular unemployment insurance benefits. When the president declares a major disaster, DUA generally is available to any unemployed worker or self-employed individual who lives, works, or is scheduled to work in the disaster area at the time of the disaster, and assuming that due to the disaster, he or she (1) no longer has a job or a place to work; (2) cannot reach the place of work; (3) cannot work due to damage to the place of work; or (4) cannot work because of an injury caused by the disaster. The maximum weekly benefit amount is determined under the provisions of the state law for unemployment compensation in the state where the disaster occurred. However, the minimum weekly amount is half (50 percent) of the average benefit amount in the state. • Unemployment Compensation for Federal Employees (UCFE). Unemployment Compensation for Federal Employees (UCFE) pays benefits to eligible former civilian federal employees who are unemployed. The states administer the program as agents of the federal government under the same terms and conditions that apply to the state’s regular unemployment compensation program. There is no payroll deduction from a federal employee’s wages for unemployment insurance protection. Benefits are paid for by the various federal agencies. The law of the state (under which the claim is filed) determines the benefit amounts, number of weeks benefits can be paid, and other eligibility conditions. • Unemployment Compensation for Ex-Service Members (UCX). Unemployment Compensation for Ex-Service Members (UCX) pays benefits to eligible ex-military personnel. In addition, the UCX program covers former members of the National Oceanographic and Atmospheric Administration (NOAA) and U.S. Public Health Service (USPHS) Commission. The states administer the program as agents of the

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federal government. To be eligible, the ex-service member must have been on active duty in a branch of the military and must have been separated from the military under honorable conditions. The law of the state (under which the claim is filed) determines the benefit amounts, number of weeks benefits can be paid, and other eligibility ­conditions. • Trade Readjustment Allowances (TRA). Trade Readjustment Allowances (TRA) provide income support to workers who have exhausted their unemployment compensation benefits and whose jobs have been affected by foreign imports. The Federal Trade Act provides special benefits under the Trade Adjustment Assistance program to workers who were laid off or had their hours reduced because their employer was adversely affected by increased imports from other countries. These benefits include paid training for a new job, financial help in making a job search in other areas, or relocation to an area where jobs are more plentiful. Workers who qualify are entitled to TRA benefits only after unemployment compensation benefits are exhausted. • Self-Employment Assistance. Self-Employment Assistance offers dislocated workers the opportunity for early re-employment. The program is designed to encourage unemployed workers to create their own jobs by starting a small business. Under these programs, the states pay a self-employed allowance, instead of regular unemployment insurance benefits, to unemployed workers while they are establishing a business and becoming self-employed. Participants receive weekly allowances while they are getting their business off the ground The program is voluntary for the states and, at the time of writing, Delaware, Maine, Maryland, New Jersey, New York, Oregon, and Pennsylvania have Self-Employment Assistance programs. Generally, in order to receive benefits, an individual must first be eligible to receive regular unemployment compensation benefits under state law. Individuals who are permanently laid off from their previous jobs and are identified as likely to exhaust regular unemployment benefits are also eligible to participate. In addition, individuals may be eligible if they are engaged full-time in self-employment activities, including entrepreneurial training, business counseling, and technical assistance. Self-employment allowances are the same weekly amounts as the worker’s regular unemployment compensation benefits. Participants work full-time on starting their business instead of looking for wage and salary jobs.

Financing Unemployment Compensation Regular state unemployment compensation programs are financed by payroll taxes paid by covered employers on the covered wages of the employees. Three states also require the employees to contribute to the program. All payroll taxes are deposited in the federal Unemployment Trust Fund. A separate account is established for each state, and unemployment benefits are paid out of each state’s account.

Employer Contributions Under the provisions of the Federal Unemployment Tax Act, or FUTA, covered employers must pay a payroll tax on the covered wages of the workers. Prior to June 30,

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2011, the federal payroll tax was 6.2 percent of the first $7,000 paid to each covered employee. After June 30, 2011, the FUTA tax rate is 6.0 percent on the same wage base. The law, however, provides a credit against the federal tax liability of up to 5.4 percent to employers who pay state unemployment taxes in a timely manner under an approved state unemployment insurance program. This credit is allowed regardless of the amount of the tax paid to the state by the employer. Thus, in states that meet the specified requirements, covered employers pay an effective federal tax of 0.6 percent on covered wages. The federal tax is not levied on workers. Because of a desire to strengthen their unemployment reserves and to allocate unemployment taxes more equitably between low- and high-wage employers, the majority of states have adopted a higher tax base than $7,000. In early 2010, the higher wage base ranged from $8,000 to $36,800. In these states, an employer pays a tax on wages paid or earned by each worker during the calendar year up to the specified wage base. In addition, most states provide an automatic adjustment of the wage base if the FUTA is amended to apply to a higher taxable wage base than that specified under state law. Some states have established flexible tax bases, that is, bases that are automatically adjusted, generally on an annual basis. Most of these states key the adjustment to some measure of previous wages.

Employee Contributions Except in three states (Alaska, New Jersey, and Pennsylvania), employee contributions are not used to finance unemployment insurance programs. It is argued that employees should not contribute because they have no control over their employment. Also, labor unions oppose employee contributions on the grounds that the contributions further reduce take-home pay and that employees already bear the tax burden as consumers in the form of higher prices. In addition, some employers with unionized employees fear greater labor union demands for higher wages if employees were required to contribute.

Experience Rating All states have some type of experience rating system by which employers are assessed an unemployment insurance tax rate based on their individual account experience; factors included in the calculation of the individual rate include unemployment insurance benefits charged to the employer’s account and taxable payroll. There are several arguments for experience rating: • Employers are encouraged to stabilize their employment. • Experience rating results in the proper allocation of unemployment costs, because firms with high unemployment must pay higher contribution rates. • Experience rating may cause some firms to have a greater interest in benefit levels, unemployment compensation legislation, preventing dishonest claims, and more efficient administration.

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There are several arguments against experience rating: • Unemployment generally is caused by cyclical factors, a deficiency in aggregate demand, and structural changes in the economy, and most employers have little control over these causes of unemployment and should not be penalized by higher rates in their firms. • Employers oppose the liberalization of unemployment benefits because employers evaluate proposed benefit increases in terms of their effect on experience rating and may lobby to oppose benefit increases. • Experience rating is opposed because lower contribution rates provide inadequate income to the system, and unemployment reserves may be depleted to dangerously low levels during severe recessions; the average employer contribution rate declines during an extended period of prosperity when the unemployment reserves should be building up rapidly, which causes the system to be underfinanced. Experience-Rating Provisions

The following section briefly describes the major features of experience-rating ­provisions. Employer Requirements. Employers must meet certain federal and state requirements before they are eligible for experience rating. First, most states require new employers to have one to three years of unemployment experience before experience rating is used. Second, many states require a minimum balance in the unemployment fund before any reduced rates are allowed. The purpose of this solvency requirement is to make certain that the fund is adequate to pay benefits. Finally, many states provide for an increase in employer contribution rates when the fund falls below certain specified levels. Experience-Rating Formulas. There are four experience-rating systems: the reserve ratio, benefit ratio, benefit-wage ratio, and payroll decline formulas. Although the formulas are complex and vary greatly, they have the common objective of establishing the relative experience of individual employers with respect to unemployment or benefit costs. Only the reserve-ratio method will be discussed here, since it is used in the majority of states and is the most popular method for determining individual employer contribution rates. The reserve-ratio system is essentially cost accounting. Each employer has an individual account which reflects payroll amounts, tax contributions, and unemployment benefits paid. The total benefits paid since the program became effective are subtracted from total employer contributions over that period. The balance is then divided by the employer’s taxable payroll, such as an average of the last three years. The higher the reserve ratio, the lower the tax rate. The employer’s contribution rate depends on the reserve ratio as well as the size of the state’s unemployment reserve fund. A reduction in the overall reserve fund may require an alternate tax schedule involving higher rates. As stated earlier, the higher

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the reserve ratio, the lower the tax rate. However, the reserve-ratio method is designed to make certain that no employer receives a rate reduction unless the employer contributes more to the fund over the years than the benefits paid to the workers. Charging of Benefits. An unemployed worker may have worked for several firms in recent years. Several methods are used to determine which employer should be charged with the benefits that the worker receives. Some states charge the most recent employer, which is based on the theory that the most recent employer has primary responsibility for the unemployment. Other states charge base-period employers in inverse chronological order. This method is based on the theory that responsibility for unemployment lessens with time. A maximum limit is placed on the amount charged to the most recent employer; when this limit is reached, the next most recent employer is charged, and so on. Finally, the majority of states charge employers in proportion to base-period wages, because it is believed that unemployment results from general labor market conditions rather than from the separations of any single employer. Noncharging of Benefits. The states recognize that certain benefit costs should not be charged to individual employers. All states have noncharging provisions by which certain benefits are not charged to an individual employer’s account but are shared instead among all employers. Noncharged benefits typically include (1) reversal of benefit awards; (2) benefits paid following a period of disqualification, such as a voluntary quit, refusal of suitable work, and misconduct; (3) benefits paid following a separation from employment for which no disqualification is imposed, such as a worker who had a good personal reason for voluntarily leaving his or her job; (4) benefits paid to workers who continue to work for the same employer on a part-time basis; and (5) the state’s share of the extended-benefits (EB) program. Voluntary Contributions. About half of the states allow employers to pay lower rates by making voluntary contributions. The voluntary contribution increases the balance in the employer’s account (in reserve-ratio states) and results in a lower rate by which the employer saves more than the amount of the voluntary contribution. Finally, provisions in all states specify the conditions under which the employer’s experience can be transferred to another employer acquiring the business.

Unemployment Trust Fund All unemployment insurance tax contributions are deposited in the Unemployment Trust Fund, which is administered by the Secretary of the Treasury. The fund is invested as a whole, but each state has a separate account that is credited with the unemployment tax contributions collected by the state, plus the state’s share of interest on investments. Trust fund balances are invested in securities of the federal government. Each state has a separate account reflecting the tax contributions and reimbursements collected by that state. In addition, there are several federal accounts that are designed for specific purposes. They include the following:

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• The employment security administration account pays for the administrative expenses of administering the federal-state unemployment compensation program. • The extended unemployment compensation account reimburses the states for the federal share of extended benefits. States with depleted reserves can borrow from the federal unemployment account. Interest is charged on loans that are not repaid by the end of the fiscal year in which they are obtained.

Administration The federal law is administered by the Employment and Training Administration, part of the Unemployment Insurance Service in the U.S. Department of Labor. Each state administers its unemployment insurance law by maintaining records, collecting taxes, determining eligibility, processing claims, and paying unemployment benefits. The unemployed worker typically registers for work and files a weekly claim for benefits at a state employment services office. Claims are usually filed by telephone or online on a state Web site. Unless there is a good reason for late reporting, the worker must file for benefits within seven days after the week for which the claim is made. Claimants who are denied benefits must be given an opportunity for a fair hearing. The amount of time the claimant has to file the appeal varies by state and generally ranges from 5 days to 30 calendar days after a benefit determination is made. State laws typically state that appeals at the initial stage will be conducted by one person who is called a referee, examiner, or administrative law judge. In most states, the decision at the first stage is final in the absence of an appeal. In other states, the official may reconsider his or her decision within the appeal period. About half of the states have a second stage of appeals, which may include a board of review, board of appeals, or appeals board to hear cases appealed from the lower tribunal. Almost all boards at the second stage consist of three members. The members of the appeals boards generally represent labor, employers, and the public.

Taxation of Benefits Under an earlier law, only part of a recipient’s unemployment insurance benefits was subject to the federal income tax. As a result of the Tax Reform Act of 1986, all unemployment insurance benefits are now taxable as ordinary income.

Temporary Disability Insurance Workers may become unemployed because of temporary illness or injury. Five states, Puerto Rico, and the railroad industry have compulsory temporary disability insurance (TDI) laws that partly indemnify covered workers for the loss of wages caused by nonoccupational illness or injury, or by maternity. TDI laws are discussed in this chapter because they complement unemployment compensation programs by providing benefits to sick or injured individuals who do not meet the “able to work”

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requirements under state unemployment compensation laws. The sickness or injury must occur off the job. Rhode Island enacted the first temporary disability law in 1942, California followed in 1946, New Jersey in 1948, New York in 1949, Puerto Rico in 1968, and Hawaii in 1969.7 Temporary disability laws are designed to pay short-term weekly cash benefits to covered workers who are temporarily disabled because of nonoccupational injury or disease. Benefits also can be paid to eligible unemployed workers who become sick or disabled while unemployed. In this section, we discuss the major features of state programs and Puerto Rico. The railroad industry program is discussed in Chapter 17.

Covered Workers TDI coverage is not the same as coverage for unemployment compensation. In jurisdictions with temporary disability insurance laws, most commercial and industrial wage and salary employees in private industry are covered under the programs. However, in certain occupations coverage is elective. In New Jersey, California, and Rhode Island, individuals who depend on prayer or spiritual healing may elect not to be covered by the contribution and benefits provisions of the laws. In California, self-employed individuals may elect coverage under specified conditions. Also, local governmental entities or agencies may elect coverage. In Hawaii, coverage is the same as the unemployment compensation law except that small agricultural employers are covered for disability benefits but not for unemployment compensation. In addition, public authorities and corporations may elect disability coverage for their employees. Also, workers entitled to receive primary Social Security retirement and survivor benefits may elect not to be covered. In Rhode Island, state and local government employees are covered for unemployment compensation but not by the disability law. However, a governmental entity except the state and its instrumentalities may elect coverage. In New Jersey, any governmental entity or instrumentality may elect coverage if covered under the unemployment compensation law.

Methods for Providing Protection In Rhode Island, all contributions are paid into a pooled state fund that pays benefits to all covered workers; all covered employers must pay into the fund, and all benefits are paid directly out of the fund. Benefits are also available from a state fund in California, New Jersey, and Puerto Rico. However, employers can contract out of the state fund by purchasing insurance from a private commercial insurer that meets certain requirements. Coverage in the state fund is automatic unless the employer or employees have a substitute private plan that meets certain statutory standards and is approved by the administrative agency. New York and Hawaii require employers to provide their own disability plan for covered workers, with employees contributing to the cost. Employers can purchase group insurance from a commercial insurer, self-insure the benefits, or purchase coverage from a competitive state fund. In addition, both New York and Hawaii have special funds that pay benefits to workers who become disabled while unemployed

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and to disabled workers whose employers fail to provide the required benefits. Finally, in those jurisdictions where private plans can be substituted for the state plan, certain statutory standards must be fulfilled.

Eligibility Requirements Eligibility requirements typically include the following: • Meet certain earnings or employment requirements • Be disabled as defined in the law • Not have disqualifying income • Satisfy a waiting period Earnings or Employment Requirements

The claimant must have a certain amount of past employment or qualifying wages during his or her base period to be eligible for benefits. The purpose is to limit benefits to persons who have a substantial attachment to the labor force. The amount of qualifying wages or weeks of employment generally is lower than the requirements for protection. Definition of Disability

A disabled worker must meet the definition of disability as stated in the law. Disability generally is defined as the inability to perform regular or customary work because of a physical or mental condition. New Jersey, New York, and Puerto Rico, however, impose stricter requirements for disability during unemployment. New Jersey requires that claimants be continuously and totally unable to perform the duties of their job. New York and Puerto Rico require that claimants be unable to perform any work for which they are reasonably qualified by training and experience. In Hawaii, claimants must be in current employment, which is an individual who was performing regular work not longer than two weeks prior to the onset of disability and would have continued to work except for the disability. Finally, all jurisdictions pay full benefits for a disability due to pregnancy. Certain disabilities are excluded. California, Hawaii, New Jersey, New York, and Puerto Rico excluded disabilities caused by willful intention, self-inflicted injuries, or injury caused by committing an illegal act. New York also excludes disabilities from an act of war after June 30, 1950. California and Puerto Rico prohibit payments while confined in an institution as a drug addict, sexual psychopath, or alcoholic. California also prohibits payments during incarceration. In Puerto Rico, benefits are not payable for disability caused by or in relation to an abortion performed for medical reasons or in cases where complications have arisen due to abortion. Disqualifying Income

The claimant must not be receiving any disqualifying income. All jurisdictions generally restrict the payment of benefits if the claimant is receiving workers’ compensa-

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tion. New York does not pay any benefits if the injury is job related, even if workers’ compensation benefits are not paid. The other jurisdictions do not pay for disabilities covered by a workers’ compensation law. However, there are certain exceptions. Hawaii does not permit duplication of benefits unless a claimant is receiving workers’ compensation benefits for permanent partial or total disability previously incurred. Also, California pays the difference in benefits if the temporary disability benefit is higher than the workers’ compensation benefit. Finally, most jurisdictions place restrictions on the payment of disability benefits if other types of income are being received. These include income from an employer’s pension, Social Security retirement or survivor benefits, or sick-leave payments. Waiting Period

A waiting period of seven consecutive days is generally required before the disability benefits are paid. In California and Puerto Rico, the waiting period is waived from the day of confinement in a hospital. In New Jersey, the weekly benefit is paid for the waiting period after disability benefits are paid for three consecutive weeks. Finally, in Rhode Island, the waiting period applies only to the first sickness in a benefit year. Benefits and Financing

In general, weekly cash benefits are paid to eligible disabled workers that are designed to replace at least half of the weekly wage loss for a certain period, subject to certain minimum and maximum limits. As of January 1, 2010, the maximum weekly amount in the states ranged from $113 in Puerto Rico ($55 for nonagricultural workers) to $987 in California. Depending on the jurisdiction, the maximum duration of benefits ranges from up to 26 weeks to up to 52 weeks. Temporary disability income benefits are financed by a payroll tax on covered ­wages. Covered employees are required to contribute to the program in all six jurisdictions. In addition, with the exception of Rhode Island and California, where the employees pay the entire cost, covered employers must also contribute to the program.

Summary • Primary objectives of unemployment compensation are to provide cash payments during involuntary unemployment, to help maintain the worker’s standard of living, to provide time to find employment, and to help unemployed workers find jobs. • Secondary objectives of unemployment compensation are to help stabilize the economy during recessions, to improve the allocation of social costs of unemployment, to promote better utilization of labor, to encourage employers to stabilize employment, and to help employers maintain a skilled work force. • Most private firms, state and local governments, and nonprofit organizations are covered for unemployment compensation. Occupations that are excluded or for

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which coverage is incomplete include self-employment, certain agricultural labor and domestic service, service performed for an employer by a spouse or minor child, student nurses and interns employed by a hospital, students working for schools, certain immigrant farm workers, certain seasonal camp workers, and railroad workers. • Eligibility requirements for unemployment compensation typically require workers to earn qualifying wages during their base period, serve a one-week waiting period in most states, be able to work and be available for work, actively seek work, and not be disqualified for benefits. • Major causes of disqualification in most states are not being able to work or not being available for work, voluntary separation from work without good cause, discharge for misconduct at work, refusal of suitable work without good cause, and unemployment resulting from a labor dispute. • The disqualification may include one or more of the following: (1) postponement of benefits for a certain number of weeks, (2) postponement of benefits for the duration of unemployment until the worker re-qualifies for benefits, or (3) a reduction in benefits otherwise payable. • The weekly benefit amount is a fraction of the worker’s wages earned during the base period, which is subject to a statutory minimum and maximum amount. The maximum duration of regular state unemployment compensation benefits is 26 weeks in most states. • Many unemployed workers exhaust their regular state benefits. Under the extended benefits (EB) program, benefits can be paid for additional weeks in states with high unemployment. When the insured unemployment rate (IUR) in a state reaches certain specified levels, the state must extend the duration of benefits normally allowed by 50 percent up to a combined total maximum of 39 weeks. • To deal with the problem of exhaustion of both regular and extended benefits, Congress on numerous occasions has enacted special temporary programs that provided additional benefits to workers who have exhausted all benefits. A recent example of such legislation is the Emergency Unemployment Compensation 2008 (EUC08) program, which provided additional weeks of benefits to workers who had exhausted regular or extended benefits. • Regular state unemployment insurance programs are financed by payroll taxes paid by covered employers on the covered wages of the employees. Three states also require the employees to contribute to the program. • All states use experience rating, by which individual employer contribution rates are based on the employer’s own unemployment experience. Experience rating is justified on the grounds that employers are encouraged to stabilize their employment; experience rating results in the proper allocation of unemployment costs; and experience rating may cause some employers to have a greater interest in the program. • Arguments against experience rating are that most employers have little control over the causes of unemployment and should not be penalized by higher rates;

Application Question   337

employers may oppose the liberalization of benefits because of the higher contribution rates they may have to pay under experience rating; and the average employer contribution rate declines during an extended period of prosperity when the unemployment reserves should be building up rapidly, which causes the system to be underfinanced. • Five states, Puerto Rico, and the railroad industry have compulsory temporary disability insurance (TDI) laws that partly indemnify covered workers for the loss of wages caused by nonoccupational sickness or injury, or by maternity.

Questions for Review 1. Explain the primary and secondary objectives of unemployment compensation programs. 2. Identify the occupations typically excluded for state unemployment compensation benefits or those for which the coverage is less than complete. 3. Describe the typical eligibility requirements to receive regular state unemployment compensation benefits. 4. Identify the situations that can disqualify a worker from receiving unemployment compensation benefits. 5. Briefly explain how the weekly unemployment benefit amount is calculated. 6. Briefly explain the major characteristics of the permanent extended-benefits (EB) program. 7. Why has Congress found it necessary at times to enact special temporary legislation that provides additional weeks of benefits to unemployed workers? 8. Explain how state unemployment compensation programs are financed. 9. Explain the arguments for and against experience rating in the financing of state unemployment insurance programs. 10. Describe briefly the major features of compulsory temporary disability insurance laws that exist in six jurisdictions and the railroad industry. In what respect do these laws complement the unemployment compensation program?

Application Question 1. Although eligibility requirements for unemployment compensation vary among the states, there are a number of common eligibility requirements. Assume that a worker meets the qualifying wages requirement and waiting period and is available for work on a full-time basis. For each of the following, indicate, with reasons, whether the worker would be eligible for weekly unemployment benefits. Treat each event separately. a. A machinist in a manufacturing plant is laid off when his department is outsourced to a manufacturing plant in China. b. A nurse in a community hospital is fired because she stole drugs that belonged to a patient.

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c. An accountant is laid off when his firm merges with another firm. A job as a waiter in a local restaurant is available. d. A butcher on the production line in a meatpacking plant quit his job because the work was boring and tedious. e. A worker laid off during a business recession finds a part-time job that pays $100 weekly. He qualifies for a weekly unemployment benefit of $300.

Internet Resources • The U.S. Department of Labor, Employment, and Training Administration is the premier source of information on all state and federal unemployment compensation programs in the United States. Its site has a detailed and updated comparison of state unemployment insurance laws and federal unemployment insurance laws. Visit this comprehensive site at www.unemploymentinsurance .doleta.gov/unemploy • The Center on Budget and Policy Priorities provides considerable information on the effectiveness of state and federal legislation tax policies, unemployment compensation, and other areas that impact economic security. Visit the site at www.cbpp.org • The National Academy of Social Insurance is a professional organization that attempts to improve public understanding of social insurance programs. It publishes timely and important research studies on social insurance programs on its Web site, including unemployment compensation. Visit the site at www.nasi.org • The W.E. Upjohn Institute for Employment Research conducts research into the causes and effects of unemployment and measures for the alleviation of unemployment. The institute analyzes the dynamics of labor markets and evaluates employment programs around the world. It publishes a substantial number of research papers dealing with unemployment compensation. Visit this site at www.upjohninst.org

Selected References Rejda, George E. “Fundamentals of Unemployment Compensation Programs.” In The Handbook of Employee Benefits, 6th ed., ed. Jerry S. Rosenbloom. New York: McGraw-Hill, 2005. Chapter 24. U.S. Department of Labor. Employment and Training Administration. “Comparison of State Unemployment Laws.” Available at www.unemploymentinsurance.doleta.gov/unemploy/statelaws.asp U.S. Department of Labor. Office of Unemployment Insurance. “Unemployment Compensation: FederalState Partnership.” April 10, 2010. Available at www.workforcesecurity.doleta.gov/unemploy/pdf/ partnership.pdf

Notes 1. The historical development of unemployment insurance in the United States is discussed in “Social Security Programs in the United States, 1993.” Social Security Bulletin 56, no. 4 (Winter 1993): 19–28; Social Security Program in the United States (Washington, DC: U.S. Government Printing

Notes  339 Office, 1973); and Daniel Nelson, Unemployment Insurance: The American Experience, 1915–1935 (Madison: University of Wisconsin Press, 1969). 2. U.S. Department of Labor, Office of Unemployment Insurance, Division of Legislation, “Unemployment Compensation, Federal-State Partnership,” April 2010. Available at www.workforcesecurity .doleta.gov/unemploy/pdf/partnership.pdf 3. Committee on Unemployment Insurance Objectives, “Unemployment and Income Security: Goals for the 1970’s, A Report of the Committee on Unemployment Insurance Objectives Sponsored by the Institute” (Kalamazoo, MI: W.E. Upjohn Institute for Employment Research, March, 1969). 4. This section is based on U.S. Department of Labor, Office of Unemployment Insurance, “Comparison of State Unemployment Insurance Laws.” Available at www.unemploymentinsurance.doleta .gov/unemploy/comparison2010.asp 5. U.S. Department of Labor, Employment and Training Administration, “Unemployment Insurance Data Summary.” Available at www.workforcesecurity.doleta.gov/unemploy/content/data.asp 6. Center on Budget and Policy Priorities, “Policy Basics: How Many Weeks of Unemployment Compensation Are Available?” Washington, DC. Updated October 11, 2011. Available at www.cbpp .org/cms/index.cfm?fa=view&id=3164 7. U.S. Department of Labor, Employment and Training Administration, “Comparison of State Unemployment Laws,” Chapter 8. Available at http://workforcesecurity.doleta.gov/unemploy/pdf/­ uilawcompar/2010/table_of_contents.pdf. See also Social Security Online, Research, Statistics & Policy Analysis, “Temporary Disability Insurance.” Social Security Programs in the United States, July 1997. Available at http://www.ssa.gov/policy/docs/progdesc/sspus/

15 Problems and Issues in

Unemployment Compensation

Student Learning Objectives After studying this chapter, you should be able to: • Understand why the proportion of unemployed workers who receive unemployment compensation benefits has declined over time. • Explain whether weekly unemployment compensation benefits are adequate in most states. • Identify the major reasons why certain claims are disqualified for unemployment compensation benefits. • Explain why millions of unemployed workers exhaust their benefits during periods of extended unemployment. • Identify the defects now found in the permanent extended-benefits (EB) program. • Explain whether the states have adequate trust fund reserves for the payment of unemployment compensation claims. • Describe the major arguments for a higher taxable wage base in financing of unemployment compensation benefits. • Explain the problem of misclassification of employees in the administration of unemployment compensation programs. • Discuss the disincentive effects now present in unemployment compensation programs. Millions of unemployed workers must rely primarily on state unemployment compensation programs as their major source of income during periods of involuntary unemployment. Yet state unemployment compensation programs presently have serious defects that limit their effectiveness in reducing economic insecurity from involuntary unemployment. In this chapter, we continue our discussion of unemployment insurance by examining several important problems and issues. These include the decline in the proportion of the unemployed who receive weekly benefits, inadequacy of benefits, high disqualification rates for certain claims, exhaustion of benefits, inadequate financ340

Decline

in the

Proportion

of

Unemployed Workers Receiving Benefits  341

ing, size of the taxable wage base, misclassification of workers, and disincentives in unemployment compensation programs. The chapter concludes with a discussion of how unemployment insurance programs could be improved.

Decline in the Proportion of Unemployed Workers Receiving Benefits Not all unemployed workers receive benefits, even workers who have a current attachment to the labor force. The proportion of unemployed workers who receive regular state unemployment compensation benefits has declined slowly over time. There are various methods for measuring the proportion of the unemployed who receive regular benefits. One common measure is the recipiency rate, which is the proportion of benefit recipients among the total number of unemployed who file for unemployment benefits. Figure 15.1 shows the recipiency rates declined from 55 percent in 1958 to reach a low of 30 percent in 1984. For the first quarter of 2010, a period of high unemployment, the recipiency rate for regular programs was only 31 percent. In addition, there is wide variation in recipiency rates among the states and jurisdictions. Figure 15.2 shows the recipiency rates for calendar year 2009, which was a year of severe unemployment when the unemployment rate reached a peak of 10.1 percent in October 2009. The recipiency rate for regular programs ranged from a high of 63 percent in Pennsylvania to a low of 20 percent in the District of Columbia; the average for the United States was 40 percent. More recently, in late 2011, the recipiency rate for the nation was only 29 percent

Reasons for the Decline Researchers have identified several factors that explain the long-term decline in the proportion of the unemployed who receive benefits. Major factors include the following: (1) tighter monetary and nonmonetary eligibility requirements at the state and federal levels to deal with solvency problems; (2) a decline in the percentage of unionized workers in the work force for whom unemployment claims have been high historically; (3) a decline in the proportion of workers employed in the manufacturing sector, in which recepiency rates earlier have been high; (4) the increasing percentage of the unemployed who live in states in which the receipt of unemployment benefits is below the national average; (5) changing demographic composition of the unemployed, where woman, youths, and newly covered workers are less likely to file for benefits; and (6) taxation of unemployment compensation benefits.1 Finally, many unemployed workers do not receive benefits because (1) they are new entrants or reentrants into the labor force and have not met the eligibility requirements, (2) they fail to file for benefits because of lack of information, or (3) they have not met the waiting period.

Violation of Social Insurance Principles The fact that only a relatively small percentage of unemployed workers in the majority of states receives unemployment benefits in an average month violates one of the

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Figure 15.1 Regular Program Insured Unemployment as a Percent of Total Unemployment, 1950–2010 



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