CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

Accrual

Budgeting

for Military

Retirees'

Health Care

P A P E R

CBO

MARCH 2002

Accrual Budgeting

for Military Retirees’

Health Care
NOTES

All years referred to in this paper are fiscal years.

Cover photo of Walter Reed Army Medical Center in Washington, D.C., appears

courtesy of that organization.
PREFACE

By recognizing the costs of deferred compensation (such as pensions) in the years

during which employees are working, rather than when the benefits are actually paid,

accrual budgeting can provide decisionmakers with better information about the full

costs of labor and better incentives to use labor cost-effectively. Therefore, accrual

budgeting is becoming increasingly important in the federal budget. That method of

budgeting for the health care costs of military retirees over age 65 will start in 2003,

and the Administration has proposed extending it to fund younger military retirees’

health care and civil service retirement benefits.

This paper, prepared at the request of the House Budget Committee, considers

options for implementing accrual budgeting for military retirees’ health care. The

analysis examines potential changes to the currently planned accrual system, including

using different accrual rates for various categories of personnel, requiring DoD’s

budget to bear the actuarial gains and losses of policy or legislative changes, charging

the military personnel accounts (rather than the Defense Health Care Program) for the

benefits, extending accrual budgeting to the care provided in the Department of

Defense’s (DoD’s) facilities, and extending accrual budgeting to military retirees

under age 65.

Russell Beland of CBO’s National Security Division prepared the report under

the supervision of J. Michael Gilmore. The report benefited from comments by

Deborah Clay-Mendez, Sarah Jennings, Greg Kiley, Sam Papenfuss, Marvin Phaup,

Rachel Schmidt, and William Trimble. The author gratefully acknowledges the

cooperation of the staff of DoD’s Office of the Actuary and Office of the Assistant

Secretary of Defense (Health Affairs).

John Skeen edited the manuscript, Christine Bogusz proofread it, and Cindy

Cleveland prepared it for publication. Kathryn Winstead produced the cover. Lenny

Skutnik produced the printed copies, and Annette Kalicki prepared the electronic

versions for CBO’s Web site (www.cbo.gov).

Dan L. Crippen

Director

March 2002

CONTENTS

INTRODUCTION AND SUMMARY 1

BACKGROUND 2

SETTING ACCRUAL CHARGES TO PROVIDE

GOOD INCENTIVES 4

Making Accrual Charges Reflect the Costs of

Different Types of Personnel 4

Allocating Actuarial Gains and Losses to DoD 5

Paying Retirees’ Medical Costs from the Military Pay Accounts 7

EXTENDING ACCRUAL BUDGETING TO ALL

RETIREES’ MEDICAL COSTS 7

Extending Accrual Budgeting to Cover the Treatment in

DoD’s Facilities 7

Extending Accrual Budgeting to Cover the Health Care for All

Military Retirees 8

1. 10 U.S.C. §1111 et seq.

2. Transmitted to the Congress by President Bush and introduced as S. 1612 by Senator Thompson on

November 1, 2001.

3. Currently, DoD is in the process of adopting this change.

INTRODUCTION AND SUMMARY

Beginning in 2003, the Department of Defense (DoD) will budget on an accrual basis

to pay for medical care for beneficiaries who are eligible for Medicare.1 In an accrual

budget, costs—such as those for deferred compensation, including pensions and

medical benefits for retirees—are recognized during the years in which the employees

are working, not when the benefits are actually paid. Because accrual budgeting can

provide decisionmakers with betterinformation about the full cost oflabor and better

incentivesto use labor cost-effectively, its use is becoming increasingly important in

the federal budget; in fact, the President’s budget for 2003 includes a proposal to

extend it to all military retirees’ health care and to civil service retirement benefits

governmentwide. But the effectiveness of accrual budgeting depends in part on how

it is implemented.

This analysis describes the accrual system that the federal government plans

to use formedical benefits for military retirees and examines some possible legislative

modifications that could be adopted to improve the accrual system before it takes

effect in 2003. Three of the potential changes would affect the way that DoD makes

accrual payments: (1) tying accrual charges for different types of personnel to the

expected future cost of their health care, (2) incorporating those actuarial gains and

losses that result from legislation or DoD’s policy changes into DoD’s budget, and

(3) requiring the military departments to pay accrual charges out of their own

appropriations for military personnel. Legislative changes along those lines could

improve the system’s ability to provide good information and incentives, although

possibly at the cost of making the system more complex. The Administration has

proposed legislation that would accomplish the third change as part of the Managerial

Flexibility Act of 2001.2

Two other potential changes would extend accrual budgeting for the medical

costs of military retirees. One, a change that would not require new legislation,

extends it to cover care provided to Medicare-eligible retirees in DoD’s facilities.3

The other, a change that would be accomplished by the Managerial Flexibility Act,

would extend it to cover health care benefits provided for military retirees who are not

eligible for Medicare. Although those extensions might provide DoD decisionmakers

with useful information and incentives, their effects would depend heavily on how

payments out of the accrual fund were determined. For example, DoD’s treatment

facilities would have little incentive to control costs if the accrual fund simply

reimbursed them for whatever they spent providing health care to Medicare-eligible

beneficiaries. Alternatively, an accrual system could encourage cost-effective
2 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE March 2002

4. In most cases, military retirees and their dependents become eligible for Medicare when the retirees

reach age 65. Therefore, the terms "Medicare-eligible beneficiaries" and "beneficiaries over age 65"

are used interchangeably.

5. The new benefits apply to Medicare-eligible military retirees and dependents who are enrolled in

Medicare Part B. Under the new provisions, those beneficiaries receive both Tricare and Medicare

benefits.

decisions about the care in DoD’s treatment facilities by linking payments from the

fund to some external indicator of what that care should cost, rather than to what

DoD actually spent.

Each ofthemodifications discussed in this paper could increase the effectiveness of the planned accrual system. Yet even with these modifications, an accrual

system would not by itself give DoD an incentive to shape the mix of in-house care

and purchased care (care provided outside the department’s facilities) for retirees on

the basis of the full cost of that care to the federal government. Because DoD pays

forthe care thatretireesreceive in the department’sfacilities, whereas Medicare pays

for most of the cost of purchased care, the department has a budgetary incentive to

encourage elderly retirees to seek purchased care, even if that arrangement may not

always represent the lowest cost to the government as a whole. If the new accrual

system is to provide information and incentives that lead to cost-effective decisions

from the perspective of the federal government as a whole, it may—over the long

run—have to be modified to put in-house and purchased care on an equal footing.

An analysis of that issue, however, is beyond the scope of this paper.

BACKGROUND

As part of its Tricare health program, the Department of Defense offers comprehensive health care benefits to military retirees and dependents who are not eligible

for Medicare.4 Until recently, however, retirees who were eligible for Medicare were

not eligible for those comprehensive benefits. Instead, they were expected to rely on

Medicare, and their benefits from DoD were limited to care in the department’s

facilities as space permitted and to certain pharmaceutical benefits.

The National Defense Authorization Act for Fiscal Year 2001 established new,

more generous health care benefits for military retirees who are also eligible for

Medicare. Beginning in 2002, beneficiaries became eligible for the additional benefits

as DoD became the second payer to Medicare, eliminating most Medicare deductibles

and copayments formerly paid by beneficiaries.5

In 2002, DoD will pay the cost of the new benefits—which it estimates will

amount to about $4 billion for this year—directly out of the funds appropriated to its
March 2002 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE 3

Defense Health Care Program. For 2003, however, the Defense Authorization Act

for Fiscal Year 2001 directs that the payments for the new health care benefits be

made from a military retiree medical account, rather than DoD’s annual budget.

Under the new system, DoD will pay an accrual charge into the fund each year for the

future health care benefits that are earned in that year. An independent board of

actuaries will set the charges for each year so that, when invested in Treasury

securities, DoD’s payments will fully fund expected future benefits. DoD will not,

however, be responsible forfunding the cost of benefits attributable to military service

before 2003. Those costs, which include the costs of medical benefits for cohorts of

current retirees, become an unfunded liability of the fund. The Treasury will make

payments into the fund to cover that liability for past service.

Accrual budgeting for the cost of deferred compensation is not new. Since

1985, DoD has budgeted for the cost of military pensions using an accrual system.

One advantage of accrual budgeting is that it can provide more accurate information

about the value of the resources devoted to national security in each year. Under an

accrual budget, DoD is charged for the future benefits payable to those people who

are currently providing military service. By contrast, with a cash system, the current

year’s defense budget reflects the cost of pensions or health care benefits provided

now to retirees who ceased contributing to national defense years earlier. Another

benefit of accrual budgeting is that it can provide better information for personnel

decisions. Under a cash system, DoD decisionmakers may be more likely to make

decisions about the size and composition of the force with little regard for the implications for future pension or medical costs for retirees. Under an accrual system, the

cost of those future benefits is reflected in DoD’s current budget through accrual

charges, potentially giving the department a better picture of the full cost of military

personnel.

In addition to its potential to provide better information and incentives, accrual

budgeting could influence the allocation of resourcesto retirees and to DoD. At least

one association of military retireessupported the use of accrual budgeting because it

believed that that approach would help protect retirees’ medical benefits from the

annual competition for appropriated funds. Payments for those benefits made from

the accrual funds are direct (entitlement) spending and are not subject to annual

appropriations. And many observers within DoD initially believed that shifting the

new benefits from cash funding in 2002 to accrual funding in 2003 would—if there

was no change in DoD’stotal budget—provide the department with windfall savings.

They expected that the accrual chargesfor today’srelatively small military would be

less than the cost of providing benefits to the large number of current retirees. That

expectation, however, appears to have been incorrect. The board of actuaries

assumed that inflation in medical costs would continue at a relatively high rate in the

future. On the basis of that assumption, DoD estimates that the accrual charge for

retirees’ medical benefits will be $8.1 billion in 2003—nearly twice what it would

have cost the department to continue to fund those benefits that year on a cash basis.
4 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE March 2002

6. See, for example, William M. Hix and William W. Taylor, A Policymaker’s Guide to Accrual

Funding of Military Retirement (RAND, 1997).

SETTING ACCRUAL CHARGES TO PROVIDE GOOD INCENTIVES

The extent to which accrual budgeting will provide clearer information and better

incentives for DoD to use resources cost-effectively depends, in large part, on how

it is implemented. A review of the accrual system that DoD now uses to budget for

military retirement reveals two weaknesses. One is that the charges DoD pays on

behalf of different types of military personnel do not reflect the expected future costs

of their retirement benefits.6 For simplicity, the charges reflect only the most basic

distinction. The other weakness is that gains or losses to the accrual fund that result

from legislated changesin the retirement system or from DoD’s policy decisions are

currently borne by the Treasury, rather than reflected in DoD’s budget. That arrangement is a concern because the incentive to make cost-effective decisions may be

weakened when decisionmakers do not bear the costs of their decisions in their own

budgets. 

In many respects, the accrual system planned for retirees’ medical benefits

mirrors the existing system for retirement pay and thus could be subject to similar

criticisms. In addition, the incentives provided by accrual charges for retirees’

medical benefits could be further weakened if they are paid from the budget of the

Defense Health Care Program, rather than from the budgets ofthe individual military

services, where the costs of most other personnel decisions are borne.

Making Accrual Charges Reflect the Costs of Different Types of Personnel

Under current law, DoD’s medical accrual payments will be uniform for all service

personnel. The only distinction in the payments will be between those for full-time

service members and those for part-time reservists. Because part-time service

members are much less likely to reach retirement, the accrual charges for them will

be only about one-fifth as high as the charges for full-time personnel. The board of

actuaries will set annual per capita charges for both groups so that the contributions,

together with the interest, will fund the expected future medical benefits.

The use of only two per capita charges—one for full-time service members

and another for part-time service members—simplifies the actuaries’ calculations.

However, an accrual system with per capita charges that varied on the basis of other

factors, such as an individual’s branch of service and status as an officer or enlisted

member, could more accurately capture the relative costs of different types of

personnel. Active-duty Air Force officers, for example, are about four times more

likely to qualify for retirement benefits than are enlisted Marines. As a result, the
March 2002 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE 5

7. Some observers of the accrual system for military retirement pay have argued that the actuaries’

estimates are inherently conservative, causing DoD to persistently pay more than is necessary to fund

the system. If that was the case, a system in which DoD amortized past gains might sometimes

provide a better signal of true costs because the gains from past years would offset some of the

expected futuremedical costsin retirement associated with a year ofservice byan Air

Force officer are several times greater than those associated with a year ofservice by

an enlisted Marine. The current accrual system, which fails to take that difference into

account, distorts the relative costs of different types of personnel.

Allocating Actuarial Gains and Losses to DoD

Under an accrual system, the accrual charges depend on projections of future costs

and interest on the fund’s balances. If those projections prove to be accurate, then

the fund’s receipts, together with its interest earnings, will cover the costs of future

benefits. If the projections are not accurate, the fund has gains and losses. A net gain

means that the contributions, and interest on those contributions, are expected to

exceed the associated future benefits. A net loss means that the contributions and

interest are not sufficient to fund the expected benefits. Gains and losses can arise

either because of factors outside the control of DoD and the Congress (for example,

if the actuaries’ assumptions about future interest rates prove inaccurate) or because

of factors within their control (namely, deliberate changes in legislation or policies).

Under the accrual system planned for retirees’ medical benefits, DoD would

not be credited for any gains and would not be charged for any losses regardless of

the reason for those gains or losses. Instead, all of the gains and losses would be

applied to, respectively, decrease or increase the contributions made by the Treasury,

which isresponsible for paying off the unfunded liabilitiesfor benefits earned before

2003. That arrangement is consistent with the treatment of gains and losses under the

accrual system for military retirement pay, a system that has been in use since 1985.

The Treasury amortizes gains and losses that arise from unexpected discrepancies between projected and actual interest rates, mortality rates, and other actuarial

factors over which DoD and Congressional decisionmakers have little control. One

advantage ofinsulating DoD from those gains and lossesisthat it avoids charging the

department too much or too little today just because it inadvertently paid an incorrect

amount in the past. Suppose, for example, that the new accrual fund for retirees’

medical benefits experienced large net lossesin its first years because of unexpectedly

rapid inflation in health care costs in the economy as a whole but that those losses

ceased once the actuaries modified their initial assumptions. Requiring DoD to

subsequently amortize a portion of those losses would generally make accrual charges

less accurate indicators of the costs of the medical benefits being earned by service

members.7
6 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE March 2002

overcharges for the current year.

Insulating DoD’s budget from gains and losses that result from changes in

legislation or the department’s policies can reduce the incentive that the decisionmakers who are responsible for DoD’s spending have to control costs for the

government as a whole. Rather than model the accrual system for medical benefits

on the military retirement system—in which the Treasury bears all gains and losses—it

may be appropriate to follow the example set by federal credit programs. Under the

Credit Reform Act of 1990, the Treasury bears the savings or costs associated with

unavoidable errorsin financial projections. If, however, the costs of credit programs

change because the terms of existing loans are modified, the agency that is responsible

bears the expense. If DoD’s health care programs for retirees followed that

precedent, the Treasury would not amortize gains and losses that arose from

legislated changes or DoD’s policy changes. Instead, DoD would bear those costs

in its budget in the year in which the changes became effective.

The military retirementsystem provides examples of how decisions could be

affected by having the Treasury bear gains and losses that result from legislative

changes or deliberate policy decisions. During the military drawdown that followed

the Cold War, for example, DoD reduced the size of the active-duty force through

variousmanagement tools. In making its personnel decisions, DoD took into account

the savings in payroll and in recruiting and training, as well as the added costs of

separation payments and incentives. However, the department did not take into

account an estimated $18 billion in gainsto the accrualfund because those gains were

to be amortized by the Treasury in its payments to the fund and not credited to DoD.

Had they been credited to DoD, the department might have chosen to retain fewer

service members until their retirement.

In anotherinstance, in 1999, legislation changed the formula used to calculate

retirement pay for service members who entered active duty after 1986 to bring their

retirement pay up to the same level as that for members who entered before then.

Because DoD’s payments into the accrual fund since 1986 were made under the

assumption that entering cohorts were going to receive the more modest retirement

package, increasing the benefitsresulted in an estimated loss of about $4.5 billion in

the accrualfund. Under the system in place (which will also apply to retirees’ medical

benefits), the Treasury is responsible for such unfunded liabilities. DoD’s budget

faced only the accrual charges, which CBO estimated at about $680 million for the

first year. If credit reform practices had applied, DoD would have faced—in addition

to the increase in accrual charges that it did see—a one-time charge of $4.5 billion

when the new retirement system took effect. And if credit reform practices were

applied to an accrual system for retirees’ medical benefits, DoD would face similar

one-time charges for actuarial gains and losses resulting from legislation or policy

changes affecting the costs of those benefits.
March 2002 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE 7

Paying Retirees’ Medical Costs from the Military Pay Accounts

Current law requires DoD to make its annual payments to the accrual fund out of

funds appropriated to the Defense Health Care Program, which is not part of the

individual military services’ budgets. One advantage of that approach is that it keeps

the costs of retirees’ medical benefits together with most of DoD’s other health care

costs. But a disadvantage is that it fails to link the costs of retirees’ health care to the

other costs of military compensation. The new accrual charges might be more

effective in providing departmental decisionmakers with information about the full

cost of military personnel and with incentivesto use them efficiently if the individual

services had to pay that cost out of their own appropriations for military compensation.

EXTENDING ACCRUALBUDGETING TO ALL RETIREES’ MEDICAL COSTS

Under the National Defense Authorization Act for Fiscal Year 2001, two important

categories of medical benefits for retirees were not covered by accrual budgeting.

One was the care provided in DoD’s own treatment facilities to Medicare-eligible

retirees, and the other was the care—whether purchased or provided in DoD’s

facilities—offered to military retirees who are not eligible forMedicare. Authority to

extend accrual budgeting to the in-house care provided to Medicare-eligible retirees

was provided in the National Defense Authorization Act for Fiscal Year 2002, and

DoD is now developing the procedures necessary to incorporate the costs of that care

in its accrual system. Unless existing law is modified, however, none of the medical

care provided to military retirees who are not eligible for Medicare will be covered

by the accrual system. DoD will instead continue to pay those costs on a cash basis,

using each year’s annual appropriation to cover the benefits provided that year. The

advantages and disadvantages of extending accrual budgeting to these two categories

of health care depend on how the system would be implemented.

Extending Accrual Budgeting to Cover the Treatment in DoD’s Facilities

In recent years, DoD has estimated that its own treatmentfacilities have provided less

than one-fourth ofthe health care used byMedicare-eligible retirees. Despite the size

of that fraction, annual costs to the department reach about $1.2 billion. DoD is

expected to issue new regulationsthat would extend accrual budgeting to coverthose

costs.

Depending on its implementation, that step could have serious implications for

the efficiency of DoD’s facilities. Suppose, for example, that the accrual fund

reimbursed DoD for whatever the department spent on retirees and that the fund’s

losses were not charged back to the department’s budget. In that case, DoD would
8 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE March 2002

have little incentive to control the costs of treating those patients. In addition, DoD

would have an incentive to attribute as much as possible of its total cost for health

care to the care of Medicare-eligible beneficiaries.

Those adverse incentives could be avoided if the payments made to DoD out

of the accrual fund on behalf of the Medicare-eligible retirees each year were not tied

directly to DoD’s reported spending on those retirees but set independently of that

spending. Under such a system, the accrual fund could pay DoD a predetermined

amount for each beneficiary to cover both DoD’s share of the costs for purchased

care and the costs for any care provided in-house. Under that approach, DoD would

have an incentive to control the costsfor care in itsfacilities. If actual costs were less

than the capitated payments (per beneficiary), DoD could keep the savings; if actual

costs were greater, DoD would be responsible for paying the difference out of its own

budget.

Even with such a system, however, DoD would not have an incentive to

choose between in-house and purchased care on the basis of their relative coststo the

federal government as a whole. As discussed earlier, DoD pays for the care that

retirees receive in its facilities, and Medicare pays for most of care that eligible

military retirees receive outside of DoD’s facilities, with the department making

copayments and paying deductibles as a secondary payer. As a result, regardless of

whether DoD relies on accrual or cash budgeting, it generally faces much lower costs

when Medicare-eligible retireesseek care outside of DoD’sfacilities—even in cases

in which relying on DoD’s facilities would be cheaper overall, perhaps because of

excess capacity there.

Ifthe purpose of an accrualsystem wasto provide information and incentives

that led to cost-effective decisionsfrom the perspective of the federal government as

a whole, thatsystem would have to reflect the full cost of care for retirees, regardless

of whetherit was delivered in military facilities or nonmilitary ones. An arrangement

that put the costs of purchased and in-house care on an equalfooting would give DoD

an incentive to provide the most cost-effective mix of care. For example, DoD could

assume responsibility for all of the costs of both purchased care and in-house care,

with no contribution from Medicare; alternatively, the department could receive payments from Medicare, as other health care providers do. An analysis of those different policy approaches is beyond the scope of this paper, however.

Extending Accrual Budgeting to Cover the Health Care for All Military Retirees

DoD’s health care costs for military retirees (and their dependents) who are not yet

eligible for Medicare remain on a cash basis even though the costs for Medicareeligible beneficiaries are shifting to an accrual basis. The planned accrual system

could provide more comprehensive information and incentivesif it covered military
March 2002 ACCRUAL BUDGETING FOR MILITARY RETIREES’ HEALTH CARE 9

retirees who are under age 65 as well asthose over 65. Again, the cost-effectiveness

would depend on how the system was implemented.

If younger retirees were included under accrual budgeting, there would be

important reasons to expand the system to cover both the costs of the care they

received in DoD’s facilities and the costs of their purchased care. If, however, only

their purchased care was covered by the accrual system, DoD could move younger

retirees to purchased care to reduce its need for appropriations (other than for the

accrual charges). Over time, the actuaries would likely update the accrual charges to

reflect the higher ratio of purchased care to DoD-provided care, but nonetheless,

DoD would benefitfromsavingsin the yearin which the care was provided and might

not be concerned about the potential for higher accrual charges in the future. DoD

would thus have a short-term financial incentive to shift retirees into purchased care

even if it was, from the perspective of the federal government as a whole, cheaper to

rely on the department’s facilities to provide that care.


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