What no one is telling you about Medicare

(MONEY Magazine) -- This Sunday morning, and for every foreseeable Sunday until at least the 2012 elections, the talking-head news shows will be crowded with members of both parties talking about the need to fix out-of-control "entitlements." Politicians like that word. It's safely nonspecific, and we're all a little suspicious of someone who feels entitled.

But make no mistake: What they'll really be talking about are your Medicare benefits. Which means they're talking about messing with your retirement.

Medicare, the federal health insurance program for seniors and disabled Americans, represents a giant chunk of your nest egg: A married couple who retired last year can expect to reap $350,000 in lifetime benefits, according to calculations by the Urban Institute's Eugene Steuerle and Stephanie Rennane. A couple who are 46 today can expect to get $525,000 worth.

Just one problem: That constantly growing cost is getting harder and harder to pay. By 2030, maintaining Medicare's current level of benefits would push up government spending to 24% of the economy, and even higher as the years roll on. Taxes, however, are set to generate revenue equal to only about 18% of gross domestic product.

It's an unsustainable gap. Something about the way health care is delivered to seniors will have to change. And with the nation in the grip of anxiety over spiking deficits and debt, a lot of Washington is in a radical mood. Republicans have put forward a plan that would completely change how Medicare works. Democrats want to stick to Medicare's basic social contract, their party's signature achievement over the past 50 years. But both sides are trying to figure out the right way for the government to say no.

What comes next is less about solutions than it is about choices. Often tough choices with high costs and tradeoffs that advocates of one remedy or another don't always talk about frankly -- probably because they know you may not like what you hear.

In this story, the first in a continuing series on Medicare, MONEY will cut through the morass to tell you what you need to know about the proposed fixes to the Medicare program. Because like it or not, your health and your wealth are at stake.

Fixing Medicare won't fix the deficit -- at least not soon.

Despite the bitter dissension in Washington lately, both sides of the political divide suddenly seem to agree on one thing: Controlling Medicare costs is the key to controlling the nation's growing budget gap.

Everybody these days seems to have a plan to bring down the deficit, on track to hit $8.5 trillion over the next 10 years if Congress sticks to current policies, and Medicare reform is prominent in most of them.

Republican House Budget Committee chairman Paul Ryan, President Obama, other Republicans and Democrats on the Hill, and soon the congressional super-committee charged with finding $1.2 trillion in new deficit cuts -- all are or will be talking up Medicare proposals. These are sure to be a focal point in the 2012 elections.

In the long run, everyone is right to worry about Medicare spending. As the projections from the nonpartisan Congressional Budget Office below show, when you look a few decades out, most of the growth in government spending as a percentage of the economy is due to the rising cost of health care programs -- and most of that cost stems from Medicare. Even Social Security, included in the blob of "everything else," looks like a small problem in comparison.

What's driving the cost of Medicare is the escalating overall price of health care, which has expanded at a rate two percentage points faster than the economy, as measured by GDP. As medical technology advances, and doctors find ways to do more (and charge more), it's been tough for Medicare to put a cap on spending. The problem will only get worse in coming decades as aging boomers flood the system and longer life spans add more years of care.

Don't count on a quick cure

Here, though, is the crucial point that many politicos gloss over: While those looming costs present a real danger to the economy 30 or 40 years out, Medicare is not the main problem behind the current deficit.

The one substantial change to the program over the past decade -- when a projected $5.6 trillion surplus turned into a $6.2 trillion cumulative shortfall -- was the addition of a $272 billion prescription drug benefit. That's not bupkis. But it's a relatively small price tag compared with $1.9 trillion in tax cuts plus the cost of two wars, a devastating recession and the stimulus packages that followed.

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Since health care outlays aren't the immediate problem, reining them in is unlikely to make a large dent in the deficit over the next one to 10 years. There are few practical ways to cut Medicare spending that could have a dramatic enough impact that soon. Proposed reforms that might take effect quickly, like boosting premiums for affluent beneficiaries, might collectively save $600 billion over 10 years -- which sounds big until you view it against that looming multi-trillion-dollar budget gap.

Meanwhile, proposals that produce more substantial savings either attempt changes to the health system that will take years to unfold or exclude people who don't have time to adjust (those over 55 today). So the really big savings wouldn't kick in until at least 2022.

All of which has Henry Aaron, an economist at the centrist-liberal Brookings Institution, worrying about "a serious disconnect in the public debate." He thinks Americans are expecting too much, too fast from Medicare reform. "People say you can't solve the deficit problem without dealing with health care," Aaron notes, "but you can't solve the near-term deficit problem by dealing with health care either."

Cuts are inevitable. The real battle is over who bears the cost.

This spring the House passed a budget resolution designed by Paul Ryan (R-Wis.) that radically overhauls Medicare. The plan is unlikely to become law in its present form, but the ideas behind it will play a pivotal role in shaping Medicare reform.

Here's how the system would work: If you are younger than 55 today, your Medicare insurance would be replaced with a fixed voucher, or what Ryan calls "premium support," which you'd use to buy a private health insurance plan. In 2022 a typical 65-year-old would get about $8,000. Plans would have to take all comers, regardless of their health, and would charge the same price to people of the same age. Your premium support would go up as you got older or sicker. Low-income seniors would get extra cash.

You get skin in the game...

Premium support attempts to fight what economists call the moral hazard problem. If your insurance picks up a lot of your medical bills, you don't have much incentive to be a picky consumer. Your doctor prescribes, you comply. Even if there might be a cheaper way to get better results.

"Medicare has inherent in it inflationary pressures that push costs up very high, very rapidly," says Jim Capretta, a former George W. Bush administration budget official now at a think tank called the Ethics and Public Policy Center.

Ryan's approach would force you to make choices about what to do with your $8,000. You could pay a lot on top of that to get a generous plan or buy a cheap one that lets you see doctors within an HMO network and leaves you with a high deductible.

How much would that system reduce the cost of care? The answer is hotly contested. Some people would spend less but might also forgo care they really needed, says Juliette Cubanski, a Medicare policy analyst at the Kaiser Family Foundation.

Gail Wilensky, who ran the Medicare system during the George H.W. Bush administration, thinks a market dynamic will help a lot, but cautions that much spending is concentrated on the very sick, whose costs have blown past any reasonable deductible. "The serious spenders are always going to be using someone else's money," she says.

Shifting to private plans also has costs: Insurers have to charge enough to pay for administration and marketing while clearing a profit. The CBO, which concedes a lot of uncertainty about how vouchers would change the market, believes total costs would go up. It estimates that private plans will be so expensive that in 2022 a typical 65-year-old would spend twice as much to get the same benefits Medicare provides. That's an extra $6,240 to you.

...but a shrinking benefit.

The voucher is also a tool to cap government spending on health care. In 2022, once the feds send you $8,000, they're done paying for the year. "What we do in Medicare today is say, 'We're going to set in motion an open-ended entitlement, and the government's going to subsidize whatever it takes to provide that package,'" says Capretta. "The Ryan budget says, 'Why don't we build a budget that sets a level of taxation that we can afford, and here's the level of entitlement spending that will fit within that?'"

The idea of imposing a limit isn't inherently conservative or liberal. Most other rich countries, with their universal insurance, set a health care budget; the reform law signed by President Obama last year tries to cap spending too. But Ryan's cap is remarkably austere.

Social Security checks to rise 3.6%

The value of his voucher would grow at the level of inflation, which is almost always less than the growth of the economy. But no industrial country keeps health spending growth below GDP growth.

"It's implausible to think costs would inflate at that level," says Boston University health economist Austin Frakt. If so, then over time premium support would buy you less and less insurance -- and less and less care.

There are countless ways to moderate the severity of the Ryan plan. Wilensky suggests a cap that grows a little faster than GDP, for instance. What's most important about the proposal, though, is not the specific growth target; it's the philosophical stake in the ground planted about how much of the cost of paying for health care should be shared collectively, through taxes, and how much should be a responsibility for you, the individual, to bear. The Ryan plan says clearly: more on you.

Read the second part of this story: Medicare: How much more will they cut?

Additional reporting by Amanda Gengler.