Letter from America part IV – Medicare, Medicaid, CMS and the CBO

The annual Federal budget is about USD 7 trn in 2025. The US runs a primary budget deficit and the US National debt (USD 35 trn!) is forecast to swell by USD 2 trn this year. Simply put, spending must be cut by 28% to balance the books today, before one contemplates any cuts to revenue in the form of lower taxes in the future and inflation in costs (which are a demographic certainty in the US, just as they are in the UK).

We, and many others, think this is an impossible target to reach (whatever Elon Musk claimed before the election) and the hope must be to slow deficit expansion and term the debt out to be more sustainable, whilst looking to reflate the coffers through economic growth. Where though can one try to find appreciable savings?

Healthcare entitlement programs are the largest single bucket of costs (followed by retiree benefits for the 68 m people over 65) and they consume around a quarter of this annual Federal expenditure (USD 1.9 trn annually, with Medicare accounting for half of this and Medicaid/CHIP around 30%). Healthcare also consumes around a third of State spending too (a further USD 1.4 trn annually).

Some 15% the Federal healthcare budget reflects transfers to the States, and one easy win to improve the Federal budget deficit would be to try to push more of these costs down onto the individual states, but this is a slight of hand because the states would then have to increase revenues (i.e. taxes) as an offset or cut benefits; such a move would hurt the Medicaid programme the most (more on this later).

Financial projections for the US Government are made by the Congressional Budget Office (CBO) and look forward on a rolling 10-year basis. Like all such projections, there is considerable scope for ‘shenanigans’ to massage the numbers by using optimistic assumptions or including yet-to-be realised savings (the US is not alone in this; recall that Rachel Reeves was said to be contemplating ‘positive’ accounting changes in the UK ahead of the last budget).

Within this, actuarial assumptions for healthcare entitlement spending are a source of considerable volatility in out-year projections, where small changes drive huge 10-year dollar outcomes. This reality, along with the sheer size of the numbers involved, makes these programmes (Medicare for the elderly and Medicaid for the poor) an enticing area for reform.

However Trump has previously made commitments in his ‘Agenda47’ manifesto not to cut entitlements for retirees (which includes Medicare). That is not the same as saying you will not change how these programmes work. Moreover, the healthcare industry is going to struggle to defend itself against such change; the US compares poorly to OECD peers on health outcomes and on overall spending per capita at every age level. We can agree with Trump on one thing - Americans healthcare does not represent good value in the eyes of consumers. Various lobbyists suggested such a view was widely held within the administration.

The recently convened budget reconciliation bill is one step on the pathway to securing Trump’s tax cuts (reconciliation is a fast-track legislative option to enact tax, spending, and debt limit changes which bypasses the filibuster tactic in the Senate; this is something that would otherwise require 60 Senate votes to avoid (and the Republicans only command 53 Senate votes). The house spending bill directs the confusingly named House Energy and Commerce Committee (which oversees many industries, including public healthcare, food safety and drug safety) to find ways to cut the deficit by at least USD 880 bn over the next decade. Whilst not all of this need come from healthcare, USD 88 bn in annual savings would represent 16% of the current Medicaid budget, which is clearly a high proportion.

The key question on most investors’ minds is: can reasonable savings be made without also cutting into the larger Medicare programme? Any shortfall of the projected savings agreed in the final bill will need to be offset with tax increases, so these numbers are of great importance.

Several ideas are on the table for Medicaid. The first is a narrowing of entitlements by enforcing work requirements. Since most beneficiaries work (perhaps as high as 90%), the impact of this is likely to be limited, albeit enough to reduce the rate of growth of the programme going forward. Only one state (Georgia) currently imposes a work requirement, with many others having removed them since the imposition of the Affordable Care Act.

A per capita cap on the Federal element of spending or other changes to the share of costs between Federal and local governments could have a greater budgetary impact, but this would push the burden onto the states rather than obviate it (currently, states are guaranteed Federal matching dollars without a cap for qualifying services to eligible enrolees under a formula called FMAP, which can go as high as 90% for some services and populations).

Will Trump care if state taxes have to rise in order for Federal taxes to fall? He probably should and the Republican Party itself almost certainly will: 33 Senators and all 435 members of the House of Representatives will face elections in November 2026, along with 36 state governors. The Republicans enjoy a majority of only five in the House and six in the Senate.

If Trump’s agenda does leave working Americans feeling poorer, or with reduced access to care, then the party may well be punished at the ballot box and he could become a lame duck President. Any changes must thus be handled with care, given how popular Medicaid is (>10% of current voters receive Medicaid. If you add in anyone related to someone on it or who has previously benefitted from it, you can get to ~50% of the electorate, since it covers maternity and paediatric care); curtailing entitlements does not poll well with voters.

Another consideration here is the disjointed nature of the care vertical in the United States. Hospitals and clinics tend to be privately owned, and poverty to cluster geographically. Therefore, one finds areas with higher levels of Medicaid patients versus private pay or Medicare and in some cases “clinic deserts” already exist where primary care especially is already hard to come by because the high proportion of Medicaid residents makes the business unviable due to the lower reimbursement rates on offer.

We spent a lot of time speaking with hospital and clinic operators during the conferences, since one of the major concerns for healthcare investors that has emerged in recent weeks is a fear of a capex slowdown impacting medical device companies and hospital suppliers on the back of any Medicare, Medicaid and ACA reforms.

We think the headline risk here is overstated, but there was a clear message that capex would be directed to geographical areas with the highest IRR. If Medicaid changes are impactful, we could see additional erosion of care capacity over time in poorer communities, which will further exacerbate the frustration of voters in these areas.

As noted previously, savings could be made on the operational side of both Medicaid and Medicare. Various programmes within Medicaid and Medicare, collectively referred to as ‘value based care’(VBC) have been shown to save money and to improve outcomes. Around 15 m Medciare beneficiaries are enrolled in VBC programmes and they are growing fast within Medicaid.

This large body of evidence surely provides both a blueprint for reform and the evidence the CBO could use to sign off on projected savings that could easily sum to hundreds of billions of dollars over a 10-year forecasting period. The improved outcomes also chime with RFK’s “Make America Healthy Again” agenda.

One might think this would be a boon for the various VBC providers. However, the picture may be more complex. One lobbyist said that the Trump Administration sees savings from VBC as something that should accrue to government, not providers per se (which they do currently under so-called risk sharing models) – “Medicare needs to get paid”.

VBC providers may need to re-demonstrate the value proposition or accept revised terms of trade (PMPM models, where the bottom line savings accrue back to government). One potential impact from DOGE having a seat at the table is a weighting toward AI-driven solutions that can rapidly be deployed at scale. Within some VBC programmes, AI enhanced data assimilation has been hugely positive for productivity in prior authorisation processes, cutting the admin work for the providers from hours to minutes.

In summary, we think it very unlikely that the CBO is going to be able to sign off on projected cuts from Medicaid that come close to offsetting the tax cuts being made permanent. We therefore think that the administration is also going to have to look at the larger Medicaid programme, even though Trump promised not to “cut” this ahead of the election.

Trump is going to have to be very careful in how he tackles changes to Medicare, but we think there are significant opportunities for savings. Medicare consists of four parts, A&B (Government administered and covering hospital (A) and outpatient (B) costs), C – Medicare Advantage (a privately administered alternative to A&B) and D – a Medicare prescription drug benefit plan.

Republicans have long rallied against the A&B programmes, arguing the government has no place in running healthcare entitlement programmes. Perhaps we will see a renewed push in favour of Medicare Advantage. Again though, care must be taken. Generally speaking, health insurers are not popular with the American public and their prior authorisation procedures delay care access and frustrate beneficiaries with burdensome bureaucracy.

Dr Oz, Trump’s pick to run CMS, has apparently made some comments on how he would like to see the programmes reformed, but likewise acknowledges that the efficiencies (i.e. lower per capita costs to the Federal government) that one might expect from Part C versus A&B do not seem to have materialised and this warrants scrutiny.

It is notable that the Medicare Advantage market has become very concentrated and Oz said he would like to see more competition to encourage investment into better benefits. This could impact margins for providers but could be offset by higher enrolment if MA becomes the default option for the programme. Could we see margin caps like we have in the Medicaid Managed Care programme? There has also been talk of standardised prior authorisations to free up physician time and make life easier for beneficiaries.

Based on what we have heard thus far, we think Dr Oz is likely to take a physician-centric approach to potential reforms and it is common sense that easier and more rapid decision-making and access to care can drive improved outcomes that will save money over the long term and improve member satisfaction. He has also talked previously of a payroll tax funding model (like National Insurance in the UK), but we are unsure how that would sit with Trump’s low tax mindset.

All of this is arising at the point where we can finally see the convergence of a higher Medicare payment rate with stabilising claims trends (following a bolus of higher activity due to the post-pandemic catch-up), after several years where Managed Care companies have struggled to control claims trend. We continue to be positive on the longer-term outlook for managed care providers, but these coming discussions around the operation of these large programmes may create an overhang.

In a broader context, the day to day operations of CMS & HHS could also benefit from reform. Everything seems opaque currently; for example, how is it that rate notices seem to be a surprise to managed care companies stuffed full of actuaries? Many also argue that the STARS rating system is causing insurers to over-invest into things that do not drive material savings for payors due to perverse incentives within these systems. We would welcome changes in these areas.

In conclusion, we think that Medicare and Medicaid could benefit from a raft of changes to improve their operations, both from the patient and physician perspective and in terms of reduced cost inflation. There are a number of providers within the investment universe that could benefit from these changes, providing the software and services that would empower these changes.

However, we struggle to see how Republican ambitions for savings will be met to the satisfaction of the CBO without meaningful cuts to entitlements or accounting shenanigans. The latter would clearly be the more positive route for the healthcare sector, but merely kicks the deficit can down the road.