Should Big Tech be Broken Up?

This post evaluates Senator Warren’s plan to break up big tech firms.  The analysis presented here supports the view that some of her proposals would assist large established firms and would reduce choices for consumers.  Google and Facebook have monopoly power in search and social media, but other large tech firms are capable of contesting these markets, the two firms compete with each other for ad revenue and face substantial competition in many markets from Apple, Amazon, Walmart and other firms. 

Introduction:

Senator Warren proposes major changes to anti-trust law and increased enforcement against big tech firms in her article  “It’s Time to Breakup Amazon, Google and Facebook.” 

Warren’s approach includes the following

She wants large companies with major Internet marketplaces to either sell only third-party goods or its own goods.   Marketplaces serving third-party sellers would be set up as a regulated platform utility.   The rule would require Amazon to separate Amazon Basics from Amazon marketplace, could prevent Amazon Prime and Netflix from selling the movies it produces and would require changes to the Apple Istore.  

She wants the newly created platform utilities to follow a standard of fair, reasonable, and nondiscriminatory dealing with users.  She also wants to restrict data transfer to third parties by platform utilities.

Separately, she would require Google to separate Google Ad sense from Google Search.

She would reverse some previous Tech mergers and make future tech mergers more difficult.  Previous mergers to be reversed include – Amazon’s purchase of Whole Foods and Zappos, Facebook’s purchase of WhatsApp and Instagram, and Google’s purchase of Waze, Nest and DoubleClick.

Warren has a really clear and simple vision of the world.  Google, Apple, Amazon, and Facebook all have monopoly power.   All four companies use their monopoly power to obtain large profits from consumers. The solution to this problem is to break up existing firms, reverse previous mergers, prevent future mergers and increased regulation.  

My view of the world is less black and white than Warren’s view.   Some of the major tech firms have high market shares potentially creating substantial monopoly power.  Some of the previous mergers were anti-competitive and need to be reversed but in some cases the advantages of the previous merger outweighed costs.  Moreover, some future mergers and acquisitions by competitors of Google and Facebook could increase competition and expand choices for consumers. 

In some cases, on-line regulation of Internet marketplaces is desirable but in other cases the regulation would leave the Internet firm at a significant disadvantage compared to traditional retailers. 

Analysis:

The theoretical case for applying antitrust procedures to Internet firms differs greatly from the theoretical case associated with applying antitrust to traditional industries like steel or oil.  Traditional firms attempt to get monopoly power in order to increase price and get large profits.  Many Internet firms like Google and Facebook do not charge anything for their services.  These firms get profit from ad revenue and from the use of their data on consumers.   They are willing to spend money to attract customers because an increase in the size of their network increases the scope and value of their network.  

Google and Facebook are not like swimming pools where at some point (typically pretty quickly on a hot day) additional swimmers make the pool less attractive.   There is no real cost of additional users to Google and Facebook.   Also, since the basic purpose of these networks is to allow people to interact and work together an increase in the size of the networks increases their value.  Why are Google Docs and Microsoft Office so popular?   People share documents.  An increase in the number of people sharing stuff or interacting can increase the value of the software or network.   

Google and Facebook have overwhelming market share and monopoly power in search and social media respectively.  Both firms have higher profitability levels than they would if the industry was competitive.  Google’s dominance in search allows it to manipulate results and favor certain sellers or merchants over other sellers and merchants.   The unchecked and unregulated power of Facebook has led to privacy violations, misuse of data and political manipulation of Democratic elections by bad actors.  The manipulation of consumers by Facebook may have resulted in Donald Trump being elected president and may similarly impact the 2020 presidential race.

High market share is an important indicator of potential monopoly power and is of great concern to industrial organization economists.   However, high market share does not automatically lead to monopoly power when markets are contestable.   The theory of contestable markets created by William Baumol asserts that high concentration may not lead to problems associated with monopoly if there are low barriers to entry and exit.  The implication of this theory for Big Tech is that the way to deal with the potential search and social media monopolies is to facilitate the entry of additional competitors.

One of the reasons why Google has a monopoly position in search is that both Google Android and Apple phones default to the Google search engine.   Google pays Apple a whole lot of money to make google search the default on its phone.  This side payment is basically an incentive to not compete and is in my view illegal collusion under existing antitrust law.  Warren did not flag this problem in her article.  Anti-trust authorities should end this arrangement.  This change would make the market for search not only contestable but actively contested.

The problem of Google’s monopoly power in search cannot be resolved by separating Google search from Google ads.  Google makes no money from search.   Virtually all of Google’s entire revenue is from its ad division.   A separate Google search division with no ad revenue would probably not be financially viable.

Believers in the theory of contestable markets assert that the key to taking on the Google and Facebook monopolies is to encourage entry and greater competition from existing tech firms. Microsoft with its unsuccessful Bing search engine and with its LinkedIn social network is already in competition with both Google and Facebook.     Ironically, Microsoft could more actively compete with both Google and Facebook by purchasing firms an activity that would be restricted by the adoption of Warren’s approach.  

For example, Microsoft could more easily compete with Google by purchasing Yelp and integrating Yelp with its search engine Bing.  Yelp may be receptive to a partnership with Microsoft because it has accused Google of anticompetitive behavior.   Microsoft would also have to purchase or develop a mapping company to compete with Google Maps, Waze and Apple Maps. 

A useful search engine must be complemented by mapping software for cases where the customer needs to move towards the item or business being searched.  The primary purpose of Google’s purchase of Waze was to prevent another firm from integrating Waze with their search algorithm.  Waze is now experiencing a slow death.  I agree with Warren that Google’s purchase of Waze was anti-competitive and should be reversed.  This type of antitrust action might prompt Apple or Microsoft to start competing with Google on search.  

Microsoft’s ability to compete with Facebook would similarly be enhanced if it purchased the blog platform Medium and integrated it with is social network LinkedIn.   This move would increase the number of LinkedIn members and would also increase activity by current users.

The case for reversing previous acquisitions made by Facebook is weak.   Prior to their purchase, Instagram and WhatsApp had fairly low revenue and income.   These firms may not have been viable on their own and other social media companies including Twitter and Snap did not have the money to make these acquisitions.  

These acquisitions did expand Facebook’s monopoly in social media, but the acquisitions also increased the ability of Facebook to compete with Amazon and Google for ad revenue.   I am unsure how the courts would weigh the benefits and harm of these mergers.  I am pretty sure that prohibiting these mergers would have reduced growth in Silicon Valley, stifled innovation and reduced tax revenues and charitable giving.

The case for breaking up Amazon is also weak at best.  Amazon is huge and has disrupted many industries and firms but large size without abnormal profits is not a reason for antitrust enforcement.    Amazon, aside from the cloud computing division the company, has low profits margins.   Amazon is in stiff competition with many brick and mortgage retail firms including Walmart, Target, CVS and other drug companies. Many of these competitors have higher profit margins than Amazon.  

Sometimes it appears as though the established firm uses anticompetitive methods to prevent competition from an on-line competitor owned by Amazon.  CVS and Target are refusing to honor their customer’s valid requests to transfer prescription to PillPack and Express Scripts has removed PilPack from its network.

The acquisition of Whole Foods by Amazon resulted in a huge shakeup in the grocery industry decreasing stock prices of several firms.  However, Whole Foods only had slightly more than 1 percent of the U.S. grocery market at the time it was acquired by Amazon, hardly a reason for concern.

Warren’s plan potentially treats a large retail firm like Walmart or Kroger differently than Amazon.   Inside a Walmart and Kroger one can find name-brand products and products produced by the store side by side.  Presumably, the same arrangement would be available on the store web page.  Under Warren’s rule, Amazon would not be allowed to put its own brands up next to a competitor’s brands.   Why should it permissible for Walmart to list name and Walmart options on the same shelf or web page and impermissible for Amazon to do the same?

The growth of Amazon by increasing competition has reduced prices to consumers and has kept inflation low.  The growth of Amazon has hurt some retailers but has helped the economy in many other ways.  An antitrust action against Amazon would do more to strengthen many of Amazon’s large competitors and would not clearly benefit consumers who benefit from the low prices offered by Amazon. 

One of the most interesting and innovative aspect of Warren’s anti-trust approach involves regulation of platform utilities, companies that arrange sales from third parties to customers.    Warren, when explaining the platform utility regulation, says companies should not be allowed to umpire and play in the same game.   

The largest adverse impact of the regulation of platform utilities involves competition in the entertainment industry.  The proposal to regulate Internet marketplaces as platform utilities favors the cable industry, Disney, and network TV over Amazon Prime, Apple, itunes, and Hulu and potentially Netflix.  Many of the best current movies and television shows are now produced by Netflix, Amazon and Apple.   These streaming services have increased choices for consumers and have allowed some people to cut the cord with local cable company monopolies.  

Streaming companies are constantly looking for high quality material from independent producers.  These company gets a fixed monthly fee from consumers who buy a subscription.  They don’t appear to guide people away from independently produced shows and movies towards content they finance. I am not sure what could be gained from preventing companies from distributing their own films.

Another area where Warren’s proposal could have a large impact is in competition for Internet related devises inside a home.  Google purchased Nest but there are still several other makers of smart thermostats.   Amazon own Ring but there are still  several other makers of smart doorbells.     There seems to be plenty of competition in this area and little need for an intervention by antitrust authorities.

Concluding Thoughts:

The growth of companies on the Internet has created a lot of competition for older established companies in the brick and mortar economy.   Consumers have often benefited through lower prices and the introduction of new products.     

Two companies, Google and Facebook, have a significant monopoly position in their respective fields.  Both companies have used their monopoly power to obtain abnormal profits, have not properly safeguarded consumer information and have at times used their power to impede competitors.  

Warren’s stringent antitrust approach would curb the power of large Internet firms but would also favor large traditional established companies.  In some cases, it is the large established firm that engages in anticompetitive behavior. Some restrictions on large Internet companies could result in higher prices and fewer choices for consumers.

 A more effective strategy for expanding competition in the Internet industry involves creating incentives for existing large tech firms to compete with Google on search and incentives for existing large tech firms to compete with Facebook on Social Media.

David Bernstein is an economist living in Colorado and the author of a policy primer addressing issues pertaining to student debt, health insurance and retirement income called “Defying Magnets:   Centrist Policies in a Polarized World.”

Modifications of the Affordable Care Act


The Democrats in the House are currently proposing legislation modifying the Affordable Care Act (ACA). This post summarizes and evaluates the new bill in Congress.

Introduction:

The Affordable Care Act (ACA) created state health insurance exchanges to facilitate the purchase of private health insurance by working-age people and their families without offers of affordable health insurance from their employer. The Republicans have attempted and continue to attempt to repeal the Affordable Care Act. The Democrats are considering a wide variety of health insurance reform plans some of which depend on improving state exchanges.

The state exchange marketplaces currently provide health insurance to around 8 million people, a small number compared to the 160 million people covered by employer-based insurance. The relatively small size of state exchange marketplaces partially stems from the eligibility rules and incentives written in the ACA. The size of the two markets also is impacted by the generous tax treatment of expenditures for health insurance by employers.

The Trump Administration and the 2018/2018 Congress made several changes to the ACA, which reduced demand for state exchange health insurance. Congressional Democrats are now proposing a bill, The Protecting Pre-existing Conditions and Making Health Care More Affordable Care Act of 2019, which makes small incremental changes to ACA rules and reverse some but not all recent Trump Administration changes to the ACA.

Go here for the bill:

https://energycommerce.house.gov/sites/democrats.energycommerce.house.gov/files/documents/Health%20Care%20Bill%20Text.pdf

Go here for a useful article on this bill.

https://www.healthaffairs.org/do/10.1377/hblog20190327.894190/full/

Go here for a useful summary.

https://energycommerce.house.gov/sites/democrats.energycommerce.house.gov/files/documents/Health%20Care%20Bill%20Section%20by%20Section.pdf

This paper provides an evaluation of the proposed bill modifying the ACA.

The analysis presented here shows that the proposed legislation makes some incremental improvements, which would strengthen state exchange marketplaces. However, even after the enactment of the new rules employer based health insurance would remain more affordable and probably more comprehensive than state exchange insurance for most of the working-age population. The new rules proposed in this act would still result in ACA state exchanges being a fringe marketplace to the larger employer-based health insurance market.

Summary of the Protecting Pre-existing Conditions and Making

Health Care More Affordable Care Act of 2019

House Democrats have introduced legislation to improve the Affordable Care Act. The main features of the ACA reforms offered by the Democrats are as follows:

· An expansion of tax credits used to subsidize the purchase of health insurance on state exchanges,

· Modification of the definition of “affordable” health care in the rule governing access to tax credits on state exchanges,

· Provide funds for reinsurance for high cost claims,

· Curtail Trump Administration waivers on essential health benefits,

· Reverse the Trump Administration executive order on short term health plans,

· Reverse Trump Administration rules promoting Association Health Plans,

· Several policies expanding ACA enrollment outreach and efforts by the Trump Administration to stifle ACA enrollment.

Analysis:

Issue One: Evaluating the impact of the expansion of the tax credit:

The new bill makes the premium tax credit more generous by capping the percent of income a household would be required to pay for premiums on state exchange policy at 8.5 percent rather than the current level of 9.86 percent.

The new bill also provides for an expansion of the tax credit to households with income greater than 400 percent federal poverty line (FPL) is a step in the correct direction.

The current law does not provide any premium tax subsidy for people in households with income over 400 percent FPL. Around 41 percent of households in the United States have income above this level and are ineligible for any premium tax credit.

The expanded subsidy could in theory attract some higher income households to state exchanges. This expanded subsidy should increase political support for ACA state exchange marketplaces. However, the number of higher income people affected by this change is likely to be small because most higher income people even after all the changes in this bill most high-income households will get better offers of health insurance from their employer than what is available on state exchanges.

The current elimination of the premium tax credit for people in households with income at 400 percent of the FPL leaves many household with a large unanticipated tax bill. The premium tax credit is claimed at the beginning of the year when annual income is difficult to anticipate. The allowable premium tax is based on actual end of year income. Households who earn more than they anticipate and earn more than 400 percent FPL must refund the premium tax credit to the IRS. The expansion of the tax credit could reduce (and depending on how it is structured) eliminate the subsidy cliff where some households owe money to the IRS because they miscalculated their income.

Issue Two: Evaluating changes in the definition of “affordable” in the rule governing eligibility for the premium tax credit.

The affordability rule applied to the premium tax credit is arcane.

Current ACA rules allow taxpayers to claim the premium tax credit if employer-based health insurance is not “affordable.” However, the affordability test is based on the cost of an individual health plan even if the household is larger than one individual.

This interpretation of the ACA was made by the IRS during the Obama Administration because of the exact wording of the statute even though the ACA required the taxpayer provide health insurance to everyone in the household. The IRS ruling is inconsistent with the clear intent of the individual mandate, which involves covering all people in the household.

This change in the definition of premium affordability used to determine eligibility for the premium tax credit will have a different economic impact for small versus large firms because only large firms are subject to the ACA employer mandate. The ACA employer mandate imposes a fine on large firms with more than 50 full time equivalent employees where the fine is based on the number of workers claiming the premium tax credit. Large firms in response to the new definition of affordability would have an incentive to change their insurance policies to assure their ESI offer is affordable under the new law. This might be accomplished by increasing their subsidy of the workers share of the premium payment or by decreasing premiums perhaps by increasing out-of-pocket expenses.

The new affordability definition for employer based insurance increases the number of people eligible for premium tax credits on state exchanges. However, some people who are newly eligible for the tax credit due to the change in the definition of eligibility might still prefer their employer’s health insurance offer to state exchange insurance. This would happen if the “unaffordable” employer offer was better than the state exchange insurance.

People often change jobs during the course of the year. A person with state exchange insurance who gets a new job with an offer of affordable health insurance would still under this proposed bill lose eligibility for the premium tax credit.

Currently, around 8 million people have state exchange health insurance compared to around 160 million with employer-based coverage. I have not seen an analysis of the impact of the expansion in premium tax credits and the new affordability definition on the size of these markets. The discussion presented here suggests the impact of this bill may be small. It would be a fun exercise to merge databases and get an estimate of this impact.

The original definition of affordability based on the IRS interpretation always troubled me. I hope it is replaced with a more rational definition.

Issue Three: Discussing an Omitted Issue the Elimination of the Individual Mandate.

The ACA includes a provision requiring most taxpayers in the United States have continuous health insurance or pay a fine to the IRS. One of the most notable “achievements” of the Trump Administration was the repeal of the individual mandate. The individual mandate was considered vital by many health care economists because it forced people to purchase health insurance prior to becoming sick and helped stabilize health insurance premiums. The individual mandate was unpopular and strongly opposed by conservatives and libertarians who considered it an assault on freedom.

The issue of the repeal of the individual mandate is not addressed in this bill. The omission of a remedy for this problem is most likely due to political considerations.

There are other less politically abrasive ways to facilitate continuous health insurance coverage, which could substitute for the repealed mandate. The existence of a tax credit for the purchase of health insurance and/or a tax credit for contributions to health savings accounts, contingent on continuous health coverage would also increase the size of the insurance pool.

Issue Four: Evaluating a Reinsurance Program

The ACA modification bill includes a provision for reinsurance payments to insurance companies for high-risk and high-cost health care cases. Reinsurance payments are generally structured as payments from the government to private insurers or as transfers among insurers. Direct payments from the government to insurance companies are often attacked as corporate welfare. The Republican Congress has refused to fund risk corridor payments approved as part of the ACA. Litigation on these risk corridor payments has moved to the Supreme Court.

Another more politically attractive way to reduce risks associated with high health care costs would have the government make direct payments to patients who need high-cost care. The government could pay part of the cost of an endocrinologist to reduce expenses associated with chronic diabetes. The government could also pay part of the share of cancer treatments, which often occur out of network. Direct government payments to patients for high cost services that are often out of network could lower the cost of health insurance on narrow network plans and reduce lost revenue from the premium tax credit, which is linked to the cost of premiums.

These direct payments, like reinsurance payments, reduce risk for the insurer and reduce out-of-pocket costs for the patient. Payments for some treatments of a particular disease could reduce the incentive for insurance companies to cherry pick and design plans that would discourage enrollment by individuals with certain diseases.

Issue Five: Trump Executive Orders Undermining ACA State Exchanges

The Trump Administration has issued three executive orders — (1) state waivers for essential benefit coverage in health insurance policies, (2) the creation of short term health plans with substantial coverage gaps, and (3) the creation of Association Health Plans — which undermine the ACA.

Waivers of Essential Health Benefits:

The waivers for insurance covering essential health benefits lowers premiums for some healthy people but worsens the risk pool and increases prices for people seeking health insurance with essential health benefits. Health plans with waivers for essential benefits can lead to coverage gaps for routine procedures and conditions. Narrow network HMOs are a better way to obtain lower premiums than plans that curtail essential health benefits. Again, one way to motivate growth of narrow-network health plans is to provide a government subsidy for limited out-of-network benefits when such services are needed.

Short Term Health Plans:

The primary advantage of short term health plans is their lower premiums. However, coverage is often inadequate with many common procedures not covered. The policies also do not cover pre-existing conditions even though critics of the ACA have acknowledged a need to maintain protections for people with pre-existing conditions. This article does a good job in documenting problems with short term health plans.

Article on Problems with Shot Term Health Plans

https://familiesusa.org/product/seven-reasons-trump-administrations-short-term-health-plans-are-harmful-families

The Democratic bill simply repeals short term health plans.

An alternative approach would allow private short term private health insurance in partnership with Medicaid. The private plan would cover people with pre-existing conditions and cover all essential health benefits up to a $50,000 expenditure limit. This approach would authorize automatic Medicaid enrollment once the $50,000 limit was breached. This new approach essentially converts Medicaid into a reinsurance program. This proposal for a private insurance/Medicaid partnership was outlined in a 2008 paper.

Medicaid Spend Down Rules and a Health Care Reform Proposal

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162887

The private health insurance/Medicaid partnership approach would be combined with repeal of existing inadequate short term health plans.

Association Health Plans:

The proposed Association Health Plans would allow small businesses to purchase their health plans from an industry group that creates an Association. Association health plans have been tried in the past and have resulted in a lot of fraud and insolvency.

Commonwealth Fund Article on Insurance Scams:

https://www.commonwealthfund.org/publications/issue-briefs/2003/aug/health-insurance-scams-how-government-responding-and-what

Commonwealth Fund Article on Muti-employer Plan insolvency

https://www.commonwealthfund.org/publications/issue-briefs/2004/mar/mewas-threat-plan-insolvency-and-other-challenges

These Trump Administration executive orders by undermining ACA state exchanges assure that employers must play a larger role in providing health insurance to their employees. The Republican party backed by conservative economists was at one point interested in replacing employer sponsored health insurance with market places where workers could directly purchase private health insurance policies. In 2008, Senator John McCain offered a plan where employer tax preferences associated with the provision of insurance were replaced with an individual tax credit for private insurance purchases.

The Republican party no longer appears interested in reducing the role of employer in the provision of health insurance to the public.

Issue Six: The Cost of Annual Re-enrollment

The ACA requires people to reenroll each year. By contrast, people with employer-based insurance remain enrolled until they change jobs.

The annual reenrollment requirement results in state exchanges having large reenrollment costs. This bill seeks more funds for annual reenrollment efforts.

A more effective approach would involve changes to ACA rules that would allow for permanent enrollment. One impediment to permanent enrollment in ACA policies involves the loss of premium tax credits for people once they obtain an offer of affordable employer based health insurance. A second issue leading to annual reenrollment is the fact that premium payments by the individual change with annual income.

Further alterations in the premium tax credit and rules governing eligibility for the credit might be needed to facilitate permanent enrollment in ACA state exchange health plans.

Concluding Remarks:

The concept of state exchange market places for health insurance policies was originally a Republican idea. The Trump Administration is vigorously undermining state health exchanges created by the ACA. Many of the plans offered by the Administration including Associated Health Plans and Health Reimbursement Accounts will result in small businesses playing a larger role in the provision of health insurance to their employees. This creates costs both in terms of time and money for small business owners.

The proposal analyzed here takes some good steps in reversing these Trump Administration policies and includes some other provisions strengthening the ACA. However, even after enactment of these proposals, state exchange marketplaces will represent a small fraction of the market for health insurance. Even after enactment of these proposals, many people will remain ineligible for premium tax credits on state exchanges and the tax advantages associated with employer based insurance will remain substantially better than tax advantages associated with state exchange insurance.

Not all Democrats are in favor of saving and strengthening ACA state exchanges. Both Medicare for all and Medicare for America (a version of Medicare for all with an opt-out provision) would eliminate state exchanges and the need for this bill. This bill and further expansions of state exchanges would be essential if the Democrats chose to add a public option to state exchanges because the public option would decrease the already relatively low demand for private insurance on state exchanges.

Authors Note: David Bernstein retired from the U.S. Treasury in 2012 and became a freelance writer and consultant. He is the author of “Defying Magnets: Centrist Policies in a Polarized World,” https://www.amazon.com/Defying-Magnets-Centrist-Policies-Polarized/dp/179668015X

Six Reasons 401(k) Contributions Should Not be Your Top Priority

Many financial advisors believe contributions to 401(k) investments should almost always be their client’s top priority.   They sort of recognize that people who can’t pay their current bills on time and have no funds for basic emergencies need to limit or even forego contributions to illiquid retirement accounts.  However, in almost all other circumstances financial advisors favor expanding 401(k) contributions over other financial priorities.  

My view is that financial advisors tend to overprioritize the importance of 401(k) contributions at the expense of several other financial priorities. Many households should lessen the accumulation of 401(k) growth when it leads to higher borrowing costs, increased lifetime debt burdens, and outstanding mortgage obligations in retirement.  Households need to evaluate the impact of excessive reliance on 401(k) savings on tax obligations in retirement, the impact of 401(k) fees on retirement savings, and how use of alternative assets outside a 401(k) account might reduce financial risk in retirement.

Six goals – (1) Improved liquidity, (2) reduction of lifetime debt payments, (3) accumulation of house equity and mortgage reduction, (4) reduction of tax obligations in retirement, (5) reduction of 401(k) fees, and (6) management of financial risks — can lead a person to delay or reduce 401(k)  contributions. We consider circumstances where these six financial goals might override the need to increase 401(k) contributions.

Improved Liquidity:   

Many young adults are leaving college with substantial debt and little or no funds saved for emergencies.   These individuals need to reduce debt, create a fund for emergencies.  They are not in a position to tie up funds in an illiquid retirement account. 

Failure to create an emergency fund and eliminate credit card debt could lead to a deterioration in a borrower’s credit rating, which could result in much higher interest rates and a lifetime of higher borrowing costs.  A person with good credit could obtain an interest rate around 60 less than a person with bad credit for a private student loan or an auto loan.   A mortgage rate could be 40 percent lower for the person with good credit.

  • I considered the impact of credit quality on lifetime interest payments for a person with good credit and a person with bad credit.   My example involves people with three loans – a $15,000 auto loan, a $40,000 student loan and a $300,000 mortgage.   The person with good credit pays $159k less than the person with bad credit over the life of the three loans.  The largest potential savings from good credit is associated with the mortgage because it is the largest loan.

Low liquidity and high debt could lead to a great deal of discomfort and distress. In the case of a natural disaster, this could involve the difference between staying in a public shelter or flying away to a vacation.  Many people without credit or cash will find it difficult to move to a new city even if the move will lead to a higher paying job.  Bad credit can make it difficult to be approved for an apartment, may result in required down payments on utilities or cell phones, may result in the denial of a job opportunity, and higher insurance premiums.

A person who decides to tie up funds in an illiquid retirement account and allows her credit rating to deteriorate will have high borrowing costs and a more stressful life.   These adverse impacts could be avoided through the following steps. 

  • Establishment of a substantial fund for emergencies prior to tying up funds in an illiquid 401(k) account.
  • Evaluate the likely impact of contributions to your 401(k) plan on your ability to repay your loan. Make sure all bills will be paid on time prior to starting 401(k) contributions
  • Reduce 401(k) contributions and make additional debt payments as soon as debt payment problems occur.

Lifetime Debt Reduction:  

Some financial analysts acknowledge that reduction in high-interest rate credit card debt should be a high priority but are okay with long term student loan or mortgage obligations because these loans have lower interest rates.  The problem is that student loans and mortgages are often huge and lead to large lifetime debt burdens. 

  • Lifetime debt payments can be reduced by around 18 percent by selecting a 10-year student loan over a 20-year student loan and by around 20 percent by selecting a 15-year mortgage over a 30-year mortgage.

Many people can only afford the payment on the shorter-term loan by reducing payments to their 401(k) plan.  People need to consider actions that minimize lifetime debt payments even if these actions result in lower contributions to a 401(k) plan.

Here are some options.

  • Young adults who take their first job after college but plan to reenter school should almost always save for their graduate school tuition rather than tie up funds in a 401(k) plan. 
  • Student borrowers should attempt to take a 10-year student loan rather than a 20-year student loan if at all possible.  Income based replacement loans and public service loans that offer the possibility of loan forgiveness exist; however, the Department of Education has refused to discharge some of these loans and reliance on these loan programs is a risky financial strategy.  A 10-year loan may be the most effective way to limit your lifetime student loan payments. 
  • Borrowers should consider repaying their student loans in fewer than 10 years to further reduce interest payments.
  • The use of a 15-year mortgage rather than a 30-year mortgage probably requires total elimination of the student loan and may require that you delay purchasing your first house.   One problem with this approach is that when housing prices rise a delay in the first house purchase will result in a higher house price.

Mortgage Debt Elimination:

More and more older people must pay mortgages during retirement.   One study using Census Department data found that people over 60 were three times higher to have a mortgage in 2015 than they were in 1980.  

Many financial advisors are okay with their clients taking a mortgage into retirement and recommend additional catch-up 401(k) contributions over additional mortgage payments.  This is often terrible advice.

Stocks tend to have higher returns over other asset classes over long term investment horizons.   However, stock returns over a 5-year to 10-year time frame are often quite low.   By contrast, a dollar invested in reducing the mortgage balance results in a certain return.

During working years contributions to 401(k) plans are exempt from income tax.   However, during retirement all disbursements from traditional 401(K) accounts are fully taxed as ordinary income.  A person with an outstanding mortgage in retirement will, all else equal, have to disburse a larger amount than a debt-free person.  The larger disbursements lead to a higher tax obligation in retirement.  

Moreover, a person with a large mortgage balance in retirement may not be able to reduce 401(k) disbursements during a market downturn, which may lead an increased risk of the person outliving her savings.

People who pay off their mortgage on or before the date they retire tend to have planned for that outcome.   Often this outcome entails taking out a 15-year mortgage when purchasing their final home.   The simplest comparison involves a person planning to retire in 15 years who takes out either a 15-year or 30-year fixed rate mortgage.  For purposes of illustration assume the loan amount is $450,000 and the interest rates are 3.8 percent for the 30-year loan and 3.3 percent for the 15-year loan.  This is similar to current mortgage rates.   The outstanding loan balance after 15 years of payments is $0 for the 15-year loan compared to $287k for the 30-year loan.

People need to make the elimination of mortgage debt prior to retirement a high priority in their financial plan.  The following steps should be considered.

  • Taking out 15-year mortgage rather than 30-year mortgages on all homes purchased during their lifetime, even if higher mortgage payments result in the borrower having to reduce 401(k) contributions.
  • Rolling over all funds received from the sale of a home into the down payment on the purchase of the subsequent home.
  • Foregoing 401(k) catch up contributions at age 50 in order to accelerate mortgage payoff prior to retirement.

The decision to take a 15-year mortgage rather than a 30-year mortgage and the decision to reduce your 401(k) contribution could increase your current year tax liability.  However, the tax reform act of 2017 reduced the number of homeowners who claim the mortgage deduction on their tax return.  My view is that financial advisors and clients often place too high a priority on immediate reductions in tax obligations and should be more focused on reduction of risk and long-term financial objectives.   

Tax Considerations:  

There are two major tax benefits associated with 401(k) contributions. Contributions to conventional 401(K) plans are exempt from tax in the year the contribution is made.   All capital gains and investment income accumulate tax free until the income is disbursed from the 401(k) account.  As a result, contributions to a 401(k) plan are a highly effective way to reduce current year taxes and to forego taxes until disbursements in retirement. 

During retirement all disbursements from conventional 401(k) plans are taxed as ordinary income, which for most people is a substantially higher rate than the tax on capital gains on assets held outside a 401(k) plan.    

Increased 401(k) contributions decrease current year taxes and delay tax obligations.   People with a high concentration of their wealth in 401(k) accounts have higher tax obligations in retirement.   People must consider the tradeoff between immediate tax reduction and future tax obligations.

Several recent tax changes have reduced the importance of the exemption of 401(k) contributions from taxes for some middle-income household.  First, the increase in the standard deduction established in the 2017 tax law reduced potential tax saving from 401(k) contributions for some households with lower marginal tax rates.   Second, households have increased contributions to health savings accounts, which are also exempt from federal and state income tax.  These recent changes may have resulted in a decrease in 401(k) contributions. 

There are several different ways you might minimize tax obligations during retirement.   All of these techniques involve investing more funds outside your conventional 401(k) plan.

  • Funds placed in Roth accounts are fully taxed in the year they are contributed but are never taxed in subsequent years.  Roth 401(k) accounts are a relatively new innovation not available at all firms.  People with income above certain levels are not allowed to contribute to a Roth IRA.   Financial advisors tend to do a good job analyzing the relative merits of Roth versus conventional retirement accounts.
  • The elimination of a mortgage prior to retirement will reduce required 401(k) disbursements, which are fully taxed.
  • Capital gains on stock not in a retirement account are taxed at a lower rate than the ordinary income tax rate.  There are significant tax advantages with holding I-bonds issues by the Treasury and municipal bonds instead of bond funds inside a 401(k) plan.

It is important to consider both current year and future tax obligations when evaluating different investment opportunities and retirement savings options.

The importance of 401(k) fees

Many small firms with 401(k) plans charge fees of more than 1.5% per year of total assets.  Fees exceeding 2.0 % per year are not uncommon.

Fees at this magnitude can substantially erode retirement savings. In a recent blog post I calculated lifetime fees for a worker who contributes to a 401(k) fee with an annual fee of 2 percent of assets.   I found lifetime fees were roughly 25 percent of the 401(K) balance on the date of retirement.   

Should you invest in a 401(k) plan, an IRA or both?

https://medium.com/@bernstein.book1958/should-you-invest-in-a-401-k-plan-an-ira-or-both-finance-memos-3d5047c1b87b

High 401(k) fees pose significant challenges to investors in the current low-interest rate environment.  The current 10-year rate is around 1.5 % and the annual fee on some plans is over 2.0 %.  This results in a negative return on bonds invested inside a 401(k) plan.

Experts argue contributions to a high-fee 401(k) plan are still appropriate when there is an employer match. Perhaps this is correct but there is something wrong with a system that provides people incentives to save in high fee accounts.  

There are steps you can take to minimize the impact of high 401(k) fees.

  • Limit contributions to the amount needed to take full advantage of the employer match.
  • In the current low-interest rate environment, decrease 401(k) investments inside bond funds. Retain a balanced portfolio by purchasing bonds directly through the Treasury at Treasury Direct where there are no transaction costs.
  • On the day you leave your present employer convert your high-cost 401(k) plan to a low-cost IRA offered by Schwab, Vanguard, or Fidelity.

People need to fully evaluate fees charged by their firm’s 401(k) plans and adopt appropriate steps to reduce the impact of these fees on the erosion of their retirement savings.

Financial Risks:

I am concerned about two types of financial risks in 401(k) plans – (1) inappropriate investments options and (2) Interest rate exposure.   

Inappropriate Investment Options:

There is a substantial finance literature indicating that low-cost index funds outperform high-cost actively managed funds.   Some firm managers ignore this literature and choose actively managed funds.  Often this choice leads to poor results and litigation.  Below is a link to an article on litigation over 401(k) investment performance.

https://www.marketwatch.com/story/401k-lawsuits-are-surging-heres-what-it-means-for-you-2018-05-09

The optimal strategy for a person working for a firm with a 401(k) plan that has poor investment options may be to only contribute enough funds to take full advantage of the employer match.  Employees at such firms need to consider opening an IRA instead of contributing to the firm 401(k) plan.   The employee should then rollover their 401(k) funds into an IRA as soon as they leave the firm.  (Some 401(k) plans may allow current employees to rollover funds into an IRA.  I don’t know the rules on this.)

Interest Rate Exposure:

Interest rates remain below historical levels and central bank interest rates are actually negative in some countries.   This situation will not last forever.  When interest rates rise the price of bonds and the price of bond funds will decrease leading to losses.

Most 401(k) plans allow for investment in broad funds but do not allow for investments in government bonds with a specific maturity date.   The advantage of investing in a government bond with a specific maturity date is the holder of the bond will receive the full par value of the bond on the day the bond matures.   By contrast, the value of shares in a bond fund will be below the purchase price of the bond fund should interest rates rise and remain high.

Most 401(k) plans include a fixed income fund as an investment option and many 401(k) investors allocate a substantial share of their funds to the fixed income funds.   These households could result in large financial losses once we return to a more normal interest rate environment.   

My only recommendation on this problem is to consider investments in zero coupon Treasury bonds that are guaranteed to have a specific value on their maturity date.

The financial exposure associated with the eventual rise in interest rates is a scenario that keeps me up late at night.  I don’t see an obvious solution.

Concluding Remarks:

Financial advisors have always stressed the importance of investing in 401(k) plans.  This advice is better suited for people with high income, abundant funds for emergencies, and little or no debt than for the typical highly leveraged young adult.   

Even after a young adult gets a decent job, eliminates onerous credit card debt and builds up a decent emergency fund there is a need to balance competing financial objectives.  Often it makes more sense for a person to minimize lifetime debt payments and increase the accumulation of house equity than to increase contributions to a 401(k) plan.  Many people can also obtain better financial results (reduced tax obligations in retirement, lower fees, and better investment opportunities) by reducing their wealth holdings inside a 401(k) account and increasing holdings outside a 401(k) account.

The author is an economist living in Colorado.   He is the author of “Defying Magnets:   Centrist Policies in a Polarized World.”  This book can be obtained on Kindle or Amazon.  

Should you invest in a 401(k) plan, an IRA, or both?

Financial Tips:   When should a person use an Individual Retirement Account rather than a 401(k) plan?   When should a person leaving an employer convert her 401(k) plan into an IRA?

Analysis:

Most financial advisors believe that workers saving for retirement should invest in a 401(k). rather than an IRA.  Many government rules favor 401(k) contributions over iRA contributions.  First, employee contribution limits for 401(k) plans are around 3 times higher than limits for IRAs.  Second employees are allowed to make additional contributions to 401(k) plans but are not allowed to make similar contributions to IRAs.  Third, many employers routinely match employee contributions.   Fourth, the IRS imposes limits on deductibility of some iRAs but not the deductibility of 401(k) plans.   Fifth, the IRS restricts Roth IRA contributions for higher income households but does not restrict contributions to Roth 401(k) plans.   

IRS rules allow 401(k) plans to automatically enroll workers who do not opt out.  However, there are situations where people are better off investing in an IRA separate from their employer than in the firm 401(k) plan. 

The main factor favoring IRAs over 401(k) plans is the higher administrative costs of 401(k) plans.  Fees on 401(k) plans are applied to the entire 401(k) balance and are often between 1 percent or 2 percent per year.  These fees can substantially erode a workers 401(k) balance over the course of the workers lifetime. 

High 401(k) fees are more prevalent at small firms than large firms. People working at a firm offering a plan charging high 401k) fees and offering little or no employer contributions need to look at other investment options than their 401(k) plan. High 401(k) fees can substantially erode retirement savings.   These fees can largely be avoided by using an IRA rather than a 401(k) plan to save for retirement.

I constructed a spreadsheet to estimate the impact of high 401(k) fees at retirement savings.   The assumptions in a baseline analysis involved a person with a starting salary of $50,000 who works for 35 years and realizes wage growth of 2% per year over her entire career.  This person contributes 10 percent of her salary to a 401(k) plan and earns an annual return of 7%.

When fees are 2 percent of the end-of-year 401(k) balance the total fees over the entire 35-year career are slightly more than $153 k compared to an ending balance of slightly less than $600 k.   

By contrast, when 401(k) fees are 0.5 % (a reasonable fee structure that exists at many firms) total fees over the 30-year career are around $48 k and the ending balance is around $830 k.

Note the difference between ending balances of the two scenarios is much larger than the difference in fees because additional 401(k) income from the lower fee compounds at the average rate of 7 percent per year.

One possible strategy for a worker at a firm that match some employee 401(k) contributions is to make a small contribution to the 401(k) to take advantage of the employer match and then invest additional funds in an IRA. This strategy may or may not be feasible depending on IRS rules governing IRA contributions, deductibility of IRA contributions, and the individual’s household Adjusted Gross Income.

The 401(k) fees are applied to all assets in the 401(k) plan.   In the current low interest rate environment, the expected return on government bonds adjusted for 401(k) fees is negative.   In this circumstance, it may make sense to place more 401(k) funds in equity and accumulate debt investments outside of a 401(k) account where they are not subject to 401(k) fees.  One alternative, which many people overlook, is direct investment in Treasury bonds and bill at Treasury Direct.

https://www.treasurydirect.gov.

Firms like Fidelity, Schwab, and Vanguard aggressively ask people who leave their employer to convert their 401(k) plan to an IRA.   This is the rare case where aggressive solicitation from financial firms is actually sound advice.  Fees on well-designed IRAs are often near 0.2%.  The decision to maintain funds in a dormant high-fee 401(k) plan could lead to a substantial loss in retirement savings.

One of the key selling points of conventional 401(k) plans is the ability of these plans to reduce current year tax obligations.   By contrast, Roth 401(k) plans and Roth IRAs do not reduce current year tax obligation but do reduce taxes in retirement.  A person with low current year tax obligations and the ability to reduce taxes through other means such as contributing to health savings account may choose to reduce or eliminate contributions to a conventional 401(k) plan.   This person might instead invest through a Roth 401(k) plan if available at her firm or through a Roth IRA.  The lack of a Roth 401(k) option may lead some investors who are concerned about tax obligation in retirement to consider a Roth IRA over a conventional 401(k) plan.

The issue of deciding between a 401(k) plan and an IRA is related to several other issues including – the choice between debt reduction and mortgage savings, the choice between investing in a health savings account or a retirement account, and the choice between a conventional and Roth IRA.    Other financial tips on these related issues will follow shortly.

Four Free Books on Kindle June 10, 2019


Innovative Solutions to the College Debt Problem

Discusses existing policies and proposals on college financial aid and student debt and comes up with several new solutions that promise to reduce the number of overextended borrowers without imposing large burdens on taxpayers.

Defying Magnets:  Centrist Policies in a Polarized World

This generation of workers is getting screwed – higher student debt, multiple problems with health insurance coverage, and difficulties saving for retirement.   Three policy primers discusses these inter-related problems.

Things to Consider Before Purchasing Long Term Care insurance

Most people can’t afford long term care insurance.     Insurance companies often raise premiums and cut benefits, years after a policy is purchased.   The possibility of needing Long term care is a major risk.  But you need to solve other problems first.  Best to minimize debt, increase 401(k) savings, buy life insurance ahead of covering this troubling risk. 

Statistical Applications of Baseball

Book teaches introductory statistics through baseball.  A bit dated but baseball is and statistics are constants and book has a number of Interesting real world examples.  

A Centrist Health Plan

Introduction:

Most of the current health care debate in the Democratic party revolves around the adoption of a single-payer health care plan or the addition of a public option to the current system.

The Medicare for-all-option offered by Senator Sanders is on paper a comprehensive solution fixing all health insurance problems.   While many countries have high-quality public health insurance, there has never been an example of a country with an advanced private system abruptly replacing it with a public system

The proposals to expand Medicaid or Medicare currently circulating in Congress could help certain communities or groups.  The provision of Medicaid on state exchange market places would be useful in several rural counties where few private insurance companies choose to compete.   A reduction in the Medicare age or a Medicare buy-in option would benefit older workers who do not have access to employer-based health insurance coverage. 

The adoption of a public option, unlike single-payer proposals does not purport to be a comprehensive solution.  The task of fixing health care system without simply blowing up the current system is difficult.   President Trump, famously observed “Nobody knew that health care can be so complicated.”     There are multiple inter-related  health problems with our current health care system.  A policy that fixes one problem (say high premiums) can worsen another (say high out-of-pocket costs).

A centrist health care plan must do more than shore up state exchange market places through new public options.  The ACA expanded coverage to millions of people but even after the enactment of the ACA many Americans lacked health insurance and under the Trump Administration the number of Americans without health insurance has increased.

This article reports that the uninsured rate went from 10.9 percent in late 2016 to 13.7 percent in December 2018.

https://www.vox.com/2019/1/23/18194228/trump-uninsured-rate-obamacare-medicaid

Moreover, even after the enactment of the  ACA many Americans saw higher premiums, higher out-of-pocket expenses, and reduced access to specialists.  Increasingly, many Americans covered by insurance choose to forego procedures rather or prescription drugs because of high out-of-pocket costs.  Simply adding a public option does not fix these problems.

The remainder of this essay outlines health care problems and centrist solutions.

Health Care Problems and Solutions

Problem One  The Erosion of the Individual Mandate:   The ACA individual mandate was repealed in a recent tax law.  As a result, some people with pre-existing conditions have an incentive to delay the purchase of health insurance until they become sick.  The repeal of the individual mandate undermines state exchange market places and increases health insurance premiums.

Potential Solution:   There are two potential solutions to this problem. 

The first potential solution involves the reinstatement of the individual mandate.  Politically, this is a difficult option because the individual mandate is unpopular and strongly opposed by libertarians and other conservatives who believe that government has no right demanding people spend money in  a particular way.

The second  approach involves creating new financial incentives in the form of tax credits and other subsidies contingent on people holding continuous health insurance coverage.

Subsidies that could be made available only to people with continuous health insurance coverage include:  (1) a tax credit for contributions to health savings accounts, (2) a partial subsidy for high cost out-of-network treatments, and (3) subsidies for some prescription drugs.   Note that a tax credit for health savings account contributions would not even require an additional explicit linkage between the tax credit and health coverage because under current law contributions to health savings accounts are only available to people who have health insurance coverage.

Problem Two: Distortions caused by growing use of health savings accounts and high deductible health plans:   The growing use of health savings accounts coupled with high deductible plans has exacerbated three problems – (1) higher out-of-pocket health care costs, (2) increase in patients forgoing prescribed medicines and medical tests, and (3) reduced funds placed in 401(k) retirement plans.

Potential Solutions:   The distortions caused by the increased use of health savings accounts and high deductible health plans can be mitigated by several policy changes.

First, lower income households would benefit from a refundable tax credit for contributions to a health savings account.  (Current law only allows deductibility of contributions to health savings account, a feature that provides less benefit to low-income low marginal tax rate households.)

Second rules governing contributions to health savings account could be altered.   Current rules only allow contributions by people with a high-deductible health plan.  The revised rule would allow health savings account contributions by people who have a plan with a lower deductible but a high coinsurance rate.   (People with high coinsurance rate plans can have substantial cost sharing obligations but may be less likely to forego needed treatments prior to the deductible being met.)

Third, many existing high deductible health plans now forego all payments on prescription drugs until health expenses exceed the deductible.   By contrast, many traditional health plans with lower deductible pay some prescription drug costs prior to the patient paying the deductible.   The combination of high deductible and absolutely no reimbursement for prescription drugs until the deductible is met results in many people with chronic health conditions like diabetes forgoing needed medicines.  This worsens health conditions and increases costs. 

A rule requiring partial reimbursement for prescription medicines needed to prevent expansion of certain diseases would reduce the incentive for people to forego prescribed medicines.  It might be possible for HHS to adopt this rule change without input by Congress because the current ACA allows high-deductible health plans to reimburse patients for certain preventive health care measures prior to the deductible being met.    

Problem Three:  The limited role of state exchange market places.   State exchange health care markets are much smaller and much less robust than the employer-based health insurance markets.  Around 8 million people are covered by state exchange market places compared to around 155 million people covered by employer-based insurance. 

 Household receiving health coverage from state exchange markets tend to be less affluent than people obtaining health insurance from employer based market.   Go to this post on my math blog for statistics on this point.

http://www.dailymathproblem.com/2019/05/comparing-employer-sponsored-and-state.html

There are relatively few young adults under age 26  in state-exchange markets compared to employer-based markets.  Go to this post in my finance blog for a discussion of this issue.

There is less choice and fewer high quality products in state exchange markets than in employer-based markets.   In some counties few health insurance companies offer coverage and often there is concern that no health insurance companies will offer health insurance in a county.  There is evidence that state exchange insurance policies are more likely to restrict access to certain hospitals and specialists.

Potential Solutions:   It should not be a surprise a small health insurance market with relatively few young adults, and relatively few affluent households will provide less desirable outcomes than a larger health insurance markets with more younger adults and a lot of affluent people. 

The characteristics and limitations of ACA state exchange market places are largely a result of the rules laid out in the ACA.

First, the ACA contains an employer mandate, which provides a financial penalty on employers with more the 50 full time equivalent employees who do not provide health insurance to their employees. The employer mandate could be modified to allow and encourage employers to pay for health insurance on state exchange market places rather than offer a company-specific plan.

Second, the ACA eliminates tax credits to people once they obtain a position offering employer-based insurance coverage.  The rule eliminating tax credits for people with employer-based health plans would be eliminated.

Third, state exchange market places do not provide any preferential tax treatment for the 41 percent of American households with income greater than 400 percent of the federal poverty line.  Households in this income group receive untaxed health insurance from their employer.  This rule reduces political support for state exchange marketplaces.   Support for state exchange marketplaces could be increased through an expanded tax credit.

A Political Note on the Role of State Exchange and Employer-Based Health insurance Marketplaces:

The introduction of state exchange market places to compete with employer-based health insurance is the central aspect of the ACA, a law that was strongly opposed by conservative economists and Republican politicians.   However, the provision of health insurance through private markets separate from the employer was an idea originated by conservative economists and supported by Republican politicians.   To be fair, there were major differences between Republican proposals, which allowed underwriting of premiums and denials of insurance for people with pre-existing conditions and the ACA.  

Republicans are on record of supporting reductions in the use of employer-based health insurance.  In fact, a health care plan offered by Senator McCain replaces the entire current employer based tax preference with a tax credit for the purchase of health insurance through state market places.   

The protections for pre-existing conditions and the limitations on underwriting of premiums increase access to health insurance for many people who would otherwise be uninsured.   (The election results of 2018 indicate the Democrats largely won this debate.)   There is some Republican support for moving the purchase of health insurance from the employer to private markets.   Could Republicans support proposals that move more people from employer-based insurance to current ACA state exchanges?

Problem Four  The introduction of short-term bare-bones health plan has increased household financial risk and undermined state exchange market places.  The  Trump Administration has enacted rules that allow use of short term health plans.   These health plans often do not cover many services that are considered essential health benefits in an ACA plan. The coverage gaps result in unanticipated bills and financial exposure.  The short term option reduces demand for ACA policies.

Potential Solutions:   There are two way to address problem caused by the introduction of ACA plan.

The first approach is to repeal the Trump era regulation and return to a system where short term health plans are prohibited.   Repeal creates a situation where people who took out short term health plans will either lose coverage or purchase an ACA plan with a higher premium.

The second approach involves modifying short term plans to allow for an annual cap but to require coverage of all essential health benefits.  People with expenditures over the annual cap would get automatic Medicaid coverage once the cap was reached.

This policy essentially converts Medicaid into a reinsurance program responsible for health care costs over the annual limit.  I loosely describe this approach in a 2008 paper on SSRN.  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162887)

Problem Five:  Lack of access to elite out-of-network hospitals and specialists.  Typically, narrow network HMOs provide excellent health care and charge lower premiums.   However, people who get extremely sick with certain illnesses require treatment by specialists that are only offered at certain hospitals.   This is called the “breaking bad” problem as portrayed by the fictional high school chemistry teacher who chooses to make meth to pay for his cancer treatments.

Potential Solutions:  The “breaking bad” problem can be solved by having the government share part of the costs of expensive specialized out-of-network care.  Having the government pay for a portion of complex treatments that could only be handled in sophisticated out-of-network hospitals would reduce premiums for limited network HMO plans.  This reduction in health care premiums would also reduce tax subsidies on health care purchases both on the ACA state exchange subsidies and the employer-based health insurance subsidies.

This proposal offers two benefits – lower premiums on basic narrow-network health care and access to more expensive out-of-network care should the narrow network be unable to treat certain health conditions.

Problem Five:  A lack of affordable health coverage for people nearing the end of their careers who are not eligible for Medicare.

Potential Solution:    One approach to this problem is to allow the purchase of Medicare by individuals 50 or over without an offer of employer-based health.

An expanded Medicare option for people over the age of 50 could be combined with a higher (old-young) age-rate premium ratio to lower costs for younger households.    

Problem Six:   Limited State Exchange Offerings and High Premiums for Certain Counties.  Some counties have few health insurance companies offering ACA coverage.   It has been reported that in 2018 around half of counties had only  insurance company offering ACA coverage.

Heritage Foundation article on counties with limited health insurance coverage

https://www.heritage.org/health-care-reform/report/2018-obamacare-health-insurance-exchanges-competition-and-choice-continue

Potential Solution:  Senator Schatz’s health insurance bill allowing states to offer health insurance on state exchanges would create another option in many counties with only one or relatively few ACA providers

Go here for a description of the Schatz-Lujn legislation:

https://www.schatz.senate.gov/press-releases/schatz-lujn-introduce-legislation-to-create-public-health-care-option

Summarizing the Centrist Health Care Plan

A comprehensive centrist health care plan might both expand and improve health insurance coverage.   It would lower premiums and reduce out-of-pocket expenses.   The simultaneous achievement of these two goals is often difficult because many policy changes that reduce premiums increase out-of-pocket costs while policies that reduce out-of-pocket costs often increase premiums.

Here are some aspects of the plan:

  • Link all new tax subsidies and the standard deduction to a requirement that  people maintain health care coverage.
  • Change rules governing health savings accounts to allow for contributions by people who have high-cost sharing plans even if the plan has a low deductible.
  • Create tax credits for contributions to health savings accounts
  • Require partial insurance coverage for prescription drugs used to treat chronic health care conditions prior to health expenses exceeding plan deductible.
  • Modify the employer mandate to encourage businesses to subsidize state exchange insurance rather than choose and administer an employer-based policy.  
  • Modify rules governing tax subsidies for insurance on state exchanges to allow people to keep their state exchange policy after obtaining offers of employer-based coverage.
  • Repeal current short-term bare bones health plans.
  • Create health plans with an annual cap while guaranteeing Medicaid coverage once health expenditures exceed the cap.
  • Create a new subsidy for out-of-network costs for people with narrow-network plans who require procedures not covered in the narrow network.
  • Allow people over 50 without access to employer-based health plan the right to buy into Medicare.
  • Modify the age-rate premium formula to lower costs for younger households.
  • Allow states to authorize the sale of Medicaid policies on state exchanges.

Authors Note:  A lot of these ideas and proposals are discussed in greater detail in  the second chapter of my policy primer “Defying Magnets:  Centrist Policies in a Polarized World”  

Defying Magnets:  Centrist Policies in a Polarized World

The first chapter of the book examines student debt policies.   The third chapter examines retirement income.  

I believe you will find the analysis and proposals innovative, potentially useful, and drastically different than what is being offered in Washington.

Overview of Health Insurance Issues


Republicans are seeking to repeal and replace the affordable care act, even as Republican candidates for office profess support for many parts of the act including protections for people with pre-existing conditions. The primary Republican achievement since 2016 involves a tax law that repealed the individual mandate and a Texas federal court ruling currently under appeal that voided the entire law because of the individual mandate repeal.

Democrats have robustly opposed Republican efforts to repeal the ACA but are now split between fixing the Affordable Care Act or moving towards a single-payer system.   Many 2020 Democratic candidates have endorsed Medicare for all without fully considering details of and implications of their proposals.

Some Democrats are now advocating proposals that would allow some private firms or some individuals to buy into Medicare or Medicaid. One advantage of adding a government (Medicare or Medicaid) option is that these options allow people to keep private insurance.

This section starts with a review of the current health care policy debates.   The analysis reaches the following conclusions.

  • Republican efforts to repeal the ACA would substantially increase the number of uninsured people in the United States.
  • Democratic Medicare for all proposals have not been fully vetted, would leave many people with private insurance worse off and would be more expensive than anticipated.
  • The combination of a decrease in the eligibility age for Medicare combined with a higher ratio of insurance premiums for older households relative to younger households could decrease the number of uninsured people in all age groups.

The section contains discussions of three technical health insurance issues with important implications for health insurance markets that have not received attention during the debate over repeal of the ACA.

The first issue involves modifications of rules governing health savings accounts and high deductible health plans.  Proposals designed to mitigate problems created by the increased use of health savings accounts and high deductible plans include:

  • Creation of a tax credit for contributions to health savings account by low-income and mid-income households.
  • Expansion of the type of health plans, which allow contributions to health savings accounts.
  • Require high deductible health plans pay a portion of prescription drugs used for chronic diseases prior to deductible being met.

The second issue involves modification of rules and incentives governing the use of employer-based insurance versus state exchange insurance.  

Proposals designed to strengthen state exchange insurance and to allow more firms to replace employer-based coverage with state exchange coverage include:

  • An expansion of the tax credit for premiums on health insurance policies purchased through state exchanges.
  • An alternative to the employer mandate for employers subsidizing the purchase of health insurance on state exchanges.
  • Financial incentives for young adults to leave their parent’s health insurance policy and obtain health insurance on state exchanges.

The third issue involves how to mitigate financial distortions caused by extremely expensive and complex health care cases.  Proposals designed to mitigate problems associated with the most expensive health care costs include:

  • Government and private firms sharing health care expenses over a certain threshold.
  • Automatic Medicaid enrollment for people purchasing a health plan with an annual benefit cap once expenditures exceed the cap.
  • Government assistance for certain health care cases that are difficult to treat in narrow-network HMOs.

The health care debate is eerily analogous to the student loan debate with each side taking extreme positions.  Republican efforts to repeal the ACA would increase the number of uninsured.  Democratic initiatives would crowd out private insurance for many households that are well served by the existing system.  The road to improving health care like the road to reduce student debt problems involves the analysis of arcane rules and incentives and the design of economically efficient alternative regulations.

PLUS Loans for Parents and Parent Income

PLUS Loans for Parents and Parent Income

Question:  How has the use of PLUS loans for parents changed over time for parents of student attending undergraduate institutions and for students attending graduate schools?   What is the share of PLUS loans taken out by parents with income in the bottom quartile?

Does it appear that parents taking out PLUS loans for students have adequate income to repay their obligations?

Why this issue is important:  Parents who have problems repaying PLUS loans are not allowed to default on the loan.   Increasingly, many parents with PLUS loan obligations have had problems repaying and in some cases the government has garnished Social Security benefits from these borrowers.   It is possible that many of the financial problems caused by use of PLUS loans could have been prevented if lenders had considered the adequacy of parent income prior to making the loan.

Data and Methodology:

I addressed this issue with TRENDSTATS from the NCES DATALAB.

https://nces.ed.gov/Datalab/trendstats/trends.aspx

TRENDSTATS allowed me to get data on use of parent plus loans by income quartile for five different survey years  — 1996, 2000, 2004, 2008 and 2012.

I created separate analysis for parents of undergraduate students and parents of graduate students.

The table on PLUS loans for undergraduates only involves parents of dependent students.

The table on PLUS loans for graduate students uses the combined income of the student and the parent.

Results:  Two tables on PLUS loan use and income quartiles over time are presented below.

Percent of Dependent Parents with PLUS Loans by Income Quartile
Year Lowest 25th  Percent Lower Middle 25th  Percent Lower Upper 25th  Percent Upper 25th  Percent Total
1996 2.96 5.56 6.38 5.65 5.06
2000 3.56 5.48 8.61 6.76 6.07
2004 3.92 6.53 9.34 8.34 6.98
2008 4.33 6.73 9.37 8.86 7.25
2012 6.22 9.17 11.33 10.87 9.27
Percentage Growth 1997 to 2012 109.91% 64.96% 77.57% 92.49% 83.27%

Sample is all parents of dependent undergraduate students

Parent Plus Loans for Graduate Student by Quartile of

Sum of Parent and Student Income

Year Lowest 25th  Percent Lower Middle 25th  Percent Upper Middle 25th  Percent Upper 25th  Percent Total
1996 6.83 3.94 2.36 0.80 3.48
2000 7.37 5.75 4.14 2.90 5.07
2004 7.98 6.18 3.44 3.87 5.51
2008 9.82 8.14 5.48 3.88 6.76
2012 11.47 7.87 5.23 3.27 7.13
% Change 67.85% 99.63% 121.73% 308.91% 104.82%

Analysis of Percent of Plus Loans Across Income Quartiles:

Undergraduate Students:

The lower upper 25th percentile had the highest share of students dependent on PLUS loans for parents in all years.

Growth rate in use of PLUS loans for parents is highest in the lowest 25th percentile.

Graduate Students:

The lowest 25th percentile consistently had the highest percent of people dependent on PLUS loans for parents.

The upper 25th percentile had the highest growth rate in the use of PLUS loans for parents; although, the PLUS loan share for this quartile remained lower than all other quartiles in 2012.

Share of PLUS Loans Taken Out by Parents in First and Second Income Quartile:

Above I discussed the percent of students in each quartile that used a PLUS loan.

Here I look at the percent of students using PLUS loans that are in particular quartiles in each income quartile.

PLUS Loans for Parents Usage
Number out of 1,000 per income quartile
Q1 Q2 Q3 Q4 Total
Undergraduates 62.2 91.7 113.3 108.7 375.9
Graduates 114.7 78.7 52.3 32.7 278.4
Share in Each Quartile
Q1 Q2 Q3 Q4 Total
Undergraduates 16.5% 24.4% 30.1% 28.9% 100.0%
Graduates 41.2% 28.3% 18.8% 11.7% 100.0%

Calculations above are for 2012

Observations on use of Parent PLUS Loans Across Income Quartiles:

Lower-income people take out a lot of PLUS loans.

16.5 percent of PLUS loans taken out by parents of undergraduates are in the lowest income quartile.

41.2 percent of PLUS loans taken out by parents of graduate students are in the lowest income quartile.

Methodological Note:

I wanted the software to provide numbers of students in each income quartile based on population weights.   I would have obtained contingency tables based on population weights in SAS or STATA if I had access to the raw data files.  TRENDSTATS does not appear to have this capability.   Alas, I don’t have access to the raw data so this could not happen.

I attempted to switch the row and column variables in TRENDSTATS but the TRENDSTATS software does not allow for automatic creation of income quartiles when parent income of dependent variable is the column variable.

How then did I get the share of loans for all income quartiles?

By definition, each quartile has the same number of observations so I assumed each group had 1000 students.   I multiplied 1000 by share of students using PLUS loans for each quartile to get PLUS loan use per 1,000 students.

The sum of these numbers is total PLUS loan use across all students.   I divided PLUS loan use by income quartile by total PLUS loan use in the population to get quartile shares.

I am very interested in understanding the advantages and limitations of the POWERSTATS and TRENDSTATS education department software and will continue to make comments that might lead to improvements in the on-line databases.

Concluding Thought:

Barring really exceptional circumstances, student debt including PLUS loans obtained by parents is not forgiven or discharged even in bankruptcy.   Lenders happily give PLUS loans to lower-income parents because the loans are guaranteed even if the lender cannot make repayments.

The combination of government guarantees for loan payments and a prohibition on discharge of loans in bankruptcy has led to a thriving debt market geared towards people with little chance of repayment.

The Elimination of Subsidized Student Loans

The Trump Administration is proposing the elimination of subsidized student loans.  This post provides estimates of the additional costs of this proposal based on the number of years students stay in school.

Introduction:   Currently, low-income undergraduate students can take out a total of $31,000 in federal student loan.  Subsidized student loans are only available to people in low-income households.  The main difference between subsidized and unsubsidized student debt is that the government pays all interest costs on subsidized debt when the student is in school while interest accrues on unsubsidized loans.

The current limit on subsidized student loans is $23,000.  The total limit on undergraduate federal student loans is $31,000.

The Trump Administration is proposing to eliminate all subsidized student loans.

The purpose of this post is to model and analyze the  impact of this policy change for a student who is planning to take full advantage of subsidized student loans.  I also examine how this financial cost depends on the number of years it takes for the student to graduate.

Methodology:   I set up a spread sheet where the key model inputs are number of years it takes for a student to graduate, the interest rate on the student loan, and the maturity of the student loan.

Key Assumptions:

In this model, I assume the student borrows $31,000/n each year where n is the number of years it takes for the student to graduate.  When subsidized loans exist the annual total borrowed for subsidized loans is $23,000/n and total unsubsidized loans for the course of the person’s undergraduate career is $8,000.

(An expanded version of this model will consider uneven borrowing scenarios, where student borrows a different amount each year or perhaps drops out from school for a few years.)

Student remain in deferment until six month after graduation or leaving school.

Student does not apply for loan deferments for economic hardships or when unemployed.

The interest rate is 5 percent.

Student loan maturity is 20 years.

The procedure to calculate lifetime costs involves two steps.

Step One: Calculate the total loan balance on the day the student borrower starts repayment.  The subsidized loan at time of repayment is equal to the balance when issued since all interest is paid for. The FV of the unsubsidized loan is determined at time of graduation and multiplied by (1+0.05)0.5 to account for the six-month delay in repayment after graduation.

Inputs of FV function:

INT interest rate 0.05 or some other assumption.

NPER number of periods in this case number of years in school.

PMT is payment in this case the annual loan amount.

PV in this case 0

Type is ! for end of period.

The FV gives the value of the loan at graduation.   Repayment is six months later.   The value of the loan at repayment is FV0.5

The total loan balance is the sum of the subsidized and unsubsidized loan balance at time of repayment.

Step Two:  Calculate total payments over the lifetime of the loan.  This is done by using PMT function to get monthly payment and then multiplying by the total number of payments.

Spreadsheet for person who graduates in four years:

row Subsidized Loans No Subsidized Loans
2 Date of First Loan Payment 9/1/10 9/1/10
3 Subsidized Loan $23,000 $0
4 Unsubsidized Loans $8,000 $31,000
5 Interest Rate 0.05 0.05
6 Number of years In school 4 4
7 Date Repayment Starts 3/2/15 3/2/15
8 FV of subsidized loans $23,000 $0
9 FV of unsubsidized Loans $9,275 $35,940
10 Total Loans $32,275 $35,940
11 Loan Maturity 20 20
12 Loan PMT -$213 -$237
13 Lifetime Payments -$51,120 -$56,925
  • The elimination of subsidized loans increases lifetime repayment costs of the loan by $5,805 when the person graduates in four years and starts repayment six months after graduation.  (The other key assumptions are a 5% student loan interest rate and a 20-year student loan.)

Impact of delays in finishing schools:

The addition cost stemming from the loss of the subsidy can be obtained by changing line 6 of the spreadsheet number of years in school.   Below we present results for # of years in school for 4, 5, and 6.

Calculations are below:

# of Years in School Payments with Subsidized Loans Payments with No Subsidies Difference
4 $51,119.83 $56,924.81 $5,805
5 $51,496.04 $58,382.62 $6,887
5 $51,884.94 $59,889.61 $8,005
  • The elimination of subsidized loans leads to even higher costs for the person who spends more years in school.   Additional lifetime costs of loans are $6,887 for the person who graduates after 5 years and $8,005 for the person who graduates after six years.

Authors Note:  My student debt book looks at existing student debt and financial aid programs and proposals offered by both the Trump Administration and candidates in the Democratic party.   I then offer my own solutions to the problem.

The book is available on Kindle.

Innovative Solutions to the College Debt Problemhttps://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446

 

Asset Allocation for Twelve Sector Funds

Asset Allocation for Twelve Sector Funds

Issue:  Under an asset allocation investment strategy, an initial allocation is assigned to all assets in a portfolio and the portfolio is rebalanced from time to time to maintain the original composition of assets.   The rebalancing can be at scheduled dates or whenever the portfolio manager observes large changes in relative asset prices.

The original allocation of assets is maintained by selling assets that do well and buying assets that do poorly.   This approach can backfire.   A hedge fund manager who bought horse and buggy stocks and sold car stocks after the introduction of the car would not have done well.  However, asset allocators who sold internet firms prior to the tech bubble in the late 1990s did quite well.

Question:   Table one below has stock price information on 12 sector ETFs offered by Vanguard for three dates – 7/1/13, 7/1/16, and 6/29/18.

Using this price data, calculate the average annual return between 7/1/13 and 7/116 and the average annual return from 7/1/16 to 6/29/18 for the 12 funds.

What do these annualized return statistics suggest about the likelihood of success of an asset allocation strategy, which starts out with equal shares of the 12 ETFs on 7/1/2013 and rebalances on 7/1/2016.

Adjusted Close Stock Price for 12 Sector Funds
Symbol Fund Description 7/1/13 7/1/16 6/29/18
VDC Consumer Stables 93.55 133.53 134.27
VDE Energy 103.12 88.25 105.08
VFH Financials 38.12 47.48 67.45
VHT Health Care 86.84 133.78 159.14
VIS Industrials 79.06 106.53 135.81
VGT Information Tech 73.07 112.61 181.42
VAW Materials 82.52 104.33 131.56
VNQ Real Estate 56.70 84.58 81.46
VOX Communications Services 68.28 94.02 84.92
VPU Utilities 72.52 106.33 115.96
GLD Gold 127.96 128.98 118.65
SLV Silver 19.14 19.35 15.15

A note on calculations:   The return between two dates is obtained from the formula (APt/ APt-n(1/n)-1

The first period is three years and the second period is two years.   (n is 3 for first period and 2 for second period.)

The table below sorts the funds from least to highest annualized return during the first period.

Annualized Rate of Return for 12 Funds
Symbol Fund Description July 2013 to July 2016 July 2016 to July 2018 Diff.
VDE Energy -5.1% 9.1% 14.2%
GLD Gold 0.3% -4.1% -4.4%
SLV Silver 0.4% -11.5% -11.9%
VFH Financials 7.6% 19.2% 11.6%
VAW Materials 8.1% 12.3% 4.2%
VIS Industrials 10.5% 12.9% 2.5%
VOX Communications Services 11.3% -5.0% -16.2%
VDC Consumer Stables 12.6% 0.3% -12.3%
VPU Utilities 13.6% 4.4% -9.2%
VNQ Real Estate 14.3% -1.9% -16.1%
VHT Health Care 15.5% 9.1% -6.4%
VGT Information Tech 15.5% 26.9% 11.4%

Observations:

Information Technology, the best performing fund in the first period, was also the best performing fund in the second period.  This asset allocation strategy would have reduced holdings of an asset, which continued to out-perform all other assets in the portfolio.

Energy, the worst performing fund, in the first period, had a return 3 percentage points over average of the 12 ETF returns in the second period.

Four of the six worst-performing sectors in the first period realized improved returns in the second period.

Five of the six best-performing funds in the first period had worse returns in the second period.  (The only exception is the previously mentioned information technology fund.)

The median annualized return in first period was 10,9 percent.   Only four funds had annualized returns over this level in the second period.

Two sectors – financials and information tech – are positive outliers in the second period.  However, financials have underperformed in last few months.

Concluding Remarks:   Information Tech, the best performer in both time periods, did spectacularly in the second period.  Asset allocators sold the best fund.

Asset allocation strategies tend to work more consistently when the investor holds broader funds, including both the overall stock market and debt funds.  Subsequent research will look at situations where asset allocation provides better results.

Authors Note:  Interested in financial problems caused by student debt.   Take this quiz on student debt trends and proposed policy changes.

http://financememos.blogspot.com/2018/07/a-student-debt-quiz.html