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Written by: Jack Manley
With the debt ceiling fast approaching investors are turning a critical eye toward federal government expenditures. Of particular interest is “entitlement spending”, or government spending that is mandated by law, with Medicare and Social Security drawing notable attention. Between an aging population and greater life expectancy, these programs have the potential to crowd out other non-defense discretionary spending, which has historically driven productivity gains.
While both Social Security and Medicare programs are facing funding shortfalls, only the questions around Social Security have realistic answers in terms of increased taxes and reduced benefits for future beneficiaries who are not near retirement age. Moreover, while the combined old-age and disability trust funds (OASDI) are expected to be depleted in 2034, there should be sufficient payroll tax income to fund at least 74% of benefits for the next 75 years.
By contrast, the Medicare questions are still largely unanswered. The Medicare Part A trust fund - which is free for most and covers in-patient hospital charges - is expected to be depleted in 2031. But this is only one part of Medicare, and premiums for other parts of the program, plus out-of-pocket costs, are expected to consume 28% of the average Social Security benefit in 2023. This number is projected to increase to 42% by 2097.
And this is only part of the burden since Americans are likely to face other Medicare headwinds. For example, higher income beneficiaries will pay more in the form of surcharges, as shown in J.P. Morgan’s Guide to Retirement. Moreover, an increasing share of these costs will be borne by the American taxpayer, labeled as “General Revenue Transfers” in the chart below, likely resulting in higher taxes.
For Americans planning for retirement, the obvious implication is to save and invest more. Beyond this, it has become increasingly necessary to have some assets outside of traditional 401(k)s and IRAs: this could include contributing to both Roth (where contributions are made on an after-tax basis) and Health Savings Accounts (HSAs), which can help beneficiaries avoid Medicare surcharges and lower taxes in retirement.
For investors, timing is important. In the short-term, debt ceiling worries could result in a spike in Treasury yields, putting downward pressure on multiples for U.S. equities and challenging extended-duration debt instruments. Over the longer-term, the possibility of entitlement spending eclipsing productivity gains could result in weaker U.S. economic growth. Over either time horizon, broad diversification will be critical for investing success.
Medicare costs, non-interest income and expenditures by source as a percentage of GDP*
Source: 2023 Medicare Trustee Report, intermediate assumptions.* Does not include out-of-pocket costs for beneficiaries (co-pays and deductibles). The tax on Social Security benefits is the tax from 50% of benefits – 85% of benefits that are taxed. The tax for up to 50% of benefits is used to pay for Social Security benefits.
Related: What Happens if the U.S. Breaches the Debt Ceiling?