The Impact of Inflation on Future Medical Care Cost Increases
Generally, the biggest driver of retiree medical liabilities (OPEB) is the projected medical care cost increases.
Inflation (especially in food and energy costs) is in the news. Since September 2021, the annual inflation rate remains over 8%[1]. In an effort to prevent an inflationary spiral, the Federal Reserve Bank has responded with a series of interest rate hikes in 2022 that have cumulatively increased the federal funds rate by 375 bps with another rate hike possible before the end of the year. Even with these increases, interest rates are still well below the rate of inflation, resulting in negative real interest rates.
How will the recent inflationary environment impact future medical care cost increases and OPEB liabilities? The answer varies depending on whether we are talking about long-term or short-term future medical care cost increases.
Short-Term Outlook on Medical Care Cost Increases
The current 8.2% annual inflation (CPI-U) increase is a weighted average of the increases in prices of a basket of goods and services. One of the components of CPI-U is physician services (1.8% of the GDP), and another is hospital services (2.1% of the GDP). What was the annual inflation rate for physician services as of September 2022? The answer is 1.8%! Hospital service inflation for this same time period was 3.8%. This past year, physicians have seen a decrease in their real wages of 6% - 7%. The physicians' CPI increase was the smallest increase of all sectors of the economy used to determine CPI-U. Why is this so? The medical sector of the economy is complex, and the typical doctor or medical practice can’t raise prices as easily as companies can. Much of the physician and hospital fees are set by the Medicare program and existing insurance contracts which could be several years in duration. Until these contracts expire it’s unknown how much of this purchasing power will be restored through rate increases. Future wage increases for physicians and other medical personnel will add to future medical cost inflation, which could lead to a price spiral.
This is one of the reasons the Federal Reserve is continuing to raise interest rates. The Federal Reserve rate hikes are meant to reduce demand which will reduce everyone’s leverage to negotiate higher prices and salaries. Despite the Federal Reserve’s efforts to control inflation, there is a risk of a recession if rates are raised to too high a level, and a risk of long-term inflation if the rates increase are not aggressive enough.
Tom Getzen, a health economist who developed the Society of Actuaries (SOA) long-term trend model, has studied the relationship between health care cost increases and economic growth and has found health care cost increases do correlate to growth or contraction of the economy but with a time lag of two to three years. A recession now would likely dampen health care cost increases over the next few years, which might offset some or all of the cost pressure to increase wages for health care workers.
One early indication of 2023 cost increases was published by Peterson KFF.[2] They studied filings by insurers to State regulators to increase premiums for Affordable Care Act (ACA) plans. The median premium increase request was for a 10% increase in premiums. This compares to health care cost increases of approximately 4% per year over the last 3 years. While this information is preliminary and far from complete, it suggests near-term increases that are higher than in recent years.
For 2023, most US employers are anticipating increases of approximately 8% - 10% for medical plan costs and 8% - 10% for pharmacy plan costs. Bolton Health consultants note that upward pressure on provider reimbursement rates has been the driving factor on medical plan cost increases, along with continued growth in demand for medical care because of COVID-19, and the accelerating cost of treating patients with chronic conditions such as diabetes, heart disease, and behavioral health conditions. Pharmacy plan increases continue to be impacted by medication price inflation, sustained growth in specialty drug expenses, and new high-cost drug therapies.
While the spike in prices we are experiencing in 2022 may only have a modest impact in medical care cost increases in 2023, it may have a larger impact in 2024 and 2025 as new contracts are negotiated between insurers, hospitals, and providers. Over the next 3 to 5 years medical and pharmacy costs will likely increase in the 8% - 12% range as medical providers and drug companies exert more upward pressure on prices, and the US health care system continues to deal with the lingering effects of the pandemic and the costs of chronic conditions among working-age Americans.
Whether the cumulative impact is as great as recent price increases will depend at least in part on how effective Federal Reserve policies are in reducing inflation, and if these policies will cause a recession.
Effects of Long-Term Inflation on Retiree Medical Plan Liabilities
Historically, long-term inflation expectations have been greater than the actual levels over recent years. Over the last several years inflation has been around 2%. The SOA long-term medical trend model has a baseline long-term inflation expectation of 2.5%.
The SOA long-term trend model is more concerned with estimating inflation within the portion of the economy that is dedicated to health care costs. A long-term increase in general inflation would have no impact on these estimates, and on the relative cost of health care compared to wages. This is because inflation is a component in the change in wages, medical costs, and interest rates. Suppose over the next 20 years inflation averages 4.5%. This 2% increase in inflation (compared to the baseline 2.5% long-term inflation assumption in the SOA model) would increase wages, medical care costs, and interest rates by the same 2% per year. Thus, for medical benefits, the higher projected costs would be discounted by an offsetting higher discount rate with no change to the resulting liabilities. Employers who offer only a fixed dollar retiree premium subsidy would see a reduction in OPEB liability due to a higher discount rate, as the real value of fixed dollar benefits would erode. This may cause pressure on plan sponsors to increase the fixed dollar subsidy to preserve more purchasing power for retirees.
Conclusion
The inflation we are experiencing has not yet fully impacted health care costs. This will change as insurers raise premiums and hospitals’ and providers’ contracts expire. Many will not expire this year. Accordingly, even if 2023 medical care cost increases are mild to moderate, there could be more medical cost increases in 2024 and 2025 that were in part due to the 2022 inflation.
There is a chance that in addition to the 2022 inflation, there may be greater future inflation than we have experienced in the recent past, as the rest of the economy tries to restore at least part of its lost purchasing power over a period of several years. If that were to occur, medical care costs would likely increase at a faster rate, however, we would not expect liabilities for retiree medical benefits to change as the higher projected future medical costs would also be discounted at a higher interest rate.
For more information, contact a Bolton consultant.
[1] The Consumer Price Index for All Urban Consumers (CPI-U) increased 8.2% from September 2021 to September 2022, a decrease from the peak annual CPI-U inflation measure of 9.1% as of June 2022. The Personal Consumption Expenditures (PCE) Price Index increased 6.2% over the same period.
[2] Peterson KFF is a partnership between the Kaiser Family Foundation and the Peterson Center on Healthcare. The Peterson-KFF Health System Tracker provides timely data on trends, drivers, and issues that impact the performance of the U.S. healthcare system.
