The Benefits and Challenges of Innovation in Healthcare

This article is part of our coverage of the 2019 Morningstar Investment Conference.

Innovations in drug technologies are accelerating, promising improved outcomes for patients. However, the costs of many of these drugs are staggering. That contributes to the need for careful financial planning that encompasses the expense of healthcare in retirement. Three Morningstar experts addressed these issues at the Morningstar Investment Conference.

Accelerating Innovation Damien Conover, director of healthcare equity research with Morningstar Research Services, explained the importance of innovation to building competitive advantages, or moats, in healthcare.

When evaluating moats of large pharmaceutical and biotech companies, Morningstar's analysts have found that the most prevalent source is intangible assets--typically patents. Conover emphasized the importance of innovation to produce the next generation drugs.

Morningstar sees that innovation coming to fruition, although market may not, with companies like wide-moat Bristol-Myers BMY currently undervalued. Overall, Morningstar's expectation for new pipeline drug sales in 2002 is much higher than consensus estimates.

"We see large-cap pharma and biotech as undervalued because the market has undervalued assets in the pipeline," said Conover.

The number of patents issued each year in the U.S. has increased significantly over the past decade, reflecting a tremendous amount of research being monetized. In addition, the consolidation of pharmacy benefit managers is cutting into drug manufacturers' pricing power and forcing them to innovate.

Cancer patients are starting to see the benefits. Immuno-oncology drugs are demonstrating excellent efficacy, and Conover expects significant sales, from virtually nothing five years ago. Such drugs don't work for everybody, but CAR-T therapy being developed by companies such as Celgene CELG and Novartis NVS is promising.

Meanwhile, gene therapy for infants with spinal muscular atrophy is showing strong results, and CGRP drugs are effectively pain for close to 20% of migraine patients. Looking ahead, Morningstar expects major breakthroughs in neurology, particular Alzheimer's.

Staggering Costs Such innovations are helping improve life expectancy and quality of life, but they come at a high price. Karen Andersen, a healthcare strategist with Morningstar Research Services, explained that drug costs impact patients harder than hospital costs: the out-of-pocket costs are a bit higher for prescription drugs than for hospital expenses, even though overall hospital spending is much higher.

Specialty drug spending has more than doubled since 2008, from almost $200 per capita to more than $400. It affects only 5% of patients but accounts for about 50% of drug spending.

The median wage in the United States is $48,000 and the average annual cost for specialty therapies is $52,000 a year. The $150,000 tab for Bristol's Opdivo is typical. Migraine drugs are more affordable at $7,000, because it is a very competitive marketplace with a lot of drugs that came onto the market around the same time. At the other extreme is Zolgensma, Novartis' SMA gene therapy, which could cost around $1.5 million.

Overall, one in four Americans struggle to afford prescription drugs. Lower-income people are hit hardest, but more than one in 10 of those who make more than $90,000 have difficulty paying for prescription drugs.

The increasing use of high-deductible health insurance plans accounts for much of that difficulty: In 2010, 25% of employee plans were high deductible, while in 2017, 44% were. Meanwhile, while Medicare patients are exposed to only 5% of costs above the catastrophic threshold, there is no cap on what they might pay. As a result, delaying treatment is an increasingly common patient choice.

Can we push back on rising drug prices? Medicare-for-all and the adoption of international price benchmarks are two approaches that would likely be reasonably effective but they are unlikely to be implemented because of political obstacles. More politically palatable options such as customer rebates at the pharmacy counter and improved cost transparency for consumers are less likely to significantly lower drug prices.

The takeaway, says Andersen: "Strong innovation is a double-edged sword. We may not be able to pay for it unless we see disruptive change."

Planning Ahead Christine Benz, Morningstar's director of personal finance, tackled the issue of planning for these costs today.

While high-deductible plans can create a financial burden, they come with the benefits of health savings accounts. Those still working can take advantage of triple tax benefits in HSAs: pretax contributions, tax-free compounding, and tax-free qualified withdrawals.

While Morningstar's research has found that some HSA options are not very good, investors might benefit from moving out of their employer's HSA to a superior option. Morningstar rates HSA Authority highly for both those using an HSA to fund ongoing medical expenses and those using it to invest for the long term.

The projected costs of healthcare during retirement can be daunting, and "long-term care expenses are the real wild card," said Benz. "About half of us will have a paid long-term care need."

Women tend to have higher usage and for longer periods. While 47% of men 65 and up will require long-term care, 58% of women will. The mean stay for men is 1.5 years, while for women it is 2.5 years. Overall, 14% of people will need long-term care for more than five years.

Medicaid currently pays 62% of long-term care costs. However, a lack of choice in care and the need to "virtually impoverish the other spouse" makes this an unattractive option, Benz said.

Meanwhile, long-term care insurance is not a great marketplace for consumers buying now, as many insurers are getting out of it. Hybrid policies combining long-term care and life insurance are increasingly popular but can be opaque and illiquid.

Here, HSA assets can help. They can be used to cover insurance premiums, with limits. Younger investors may want to save aggressively within an HSA to directly cover the costs of long-term care in the future.

At any age, said Benz, individuals should not delay discussion of long-term care. Planning ahead will maximize options.