Despite a steady drumbeat of media coverage that Baby Boomers aren’t saving enough for retirement, a recent PwC survey of Boomers found that their biggest fear about retirement isn’t actually running out of money before the end of retirement, but how they’re going to handle their health care costs in retirement.
That fear isn’t necessarily surprising, given annual studies showing what a substantial cost health care expenses in retirement can be. A recent study by the Employee Benefits Research Institute (EBRI) found that a couple retiring today needs a whopping $273,000 to have a 90% chance of covering their health care costs in retirement (including Medicare, Medigap supplemental insurance coverage, and out-of-pocket spending). Fidelity has similarly estimated the cost at $280,000. And these estimates are just for medical expenses, and exclude potential costs for long-term care.
Yet while these dollar amounts may seem like eye-popping “big” numbers, the reality is that retiree health expenses aren’t actually needed all at once upon retiring. In fact, the typical savings requirements for retiree health care costs are really little more than a moderate ongoing annual dollar amount.
For instance, a recent joint study between Vanguard and Mercer Health and Benefits on planning for retiree health care costs found that for a typical 65-year-old woman, the median annual health care expense in retirement is “just” $5,200/year.
Of course, that expense may continue for 20+ years – adding up to more than $100,000, in lump sum form. But if ongoing health care expenses will be considered as a lump sum, then it’s important to consider income streams in retirement as lump sum assets as well. And the “lump sum” value of the average $1,294/month Social Security benefit is nearly $280,000 for males and $335,000 for females (over $600,000 as a married couple!), while couples who each earned the maximum Social Security benefit have a combined Social Security lump sum value of over $1.1 million!
That means as an ongoing annual expense, health care costs in retirement can actually be quite manageable as part of an overall budget. And when evaluated as a lump, they’re still far less than just the benefits of Social Security alone, never mind a retiree’s actual assets saved for retirement!
Real Factors That Influence Annual Health Care Costs in Retirement
The other reason why it’s so important to project health care expenses in retirement as annual expenses rather than a lump sum is that just looking at the lump sum equivalent confuses two key factors that drive (cumulative) health care costs in retirement.
The first major factor is longevity: The longer a retiree lives, the larger the cumulative cost of health care in retirement. Spending $5,000/year for 30 years (from age 65 to 95) requires $150,000 to cover the cost (assuming the growth rate on assets matches the rate of health care inflation rate). A retiree who lives only 15 years requires only half that amount, or $75,000.
The second major factor is simply the amount per year of any particular retiree’s health care expenses, which will be impacted heavily by his/her health care status and the existence of any chronic conditions. For instance, an unhealthy individual with a 15-year life expectancy who spends $10,000/year on health care expenses in retirement may have the same 15 x $10,000 = $150,000 lump sum obligation as an ultra-healthy retiree spending only $5,000/year but anticipating 30 years of retirement spending (where 30 x $5,000 = $150,000 again). But in practice, an unhealthy individual planning $10,000/year for a limited period of time has very different planning needs than someone who needs $5,000/year for twice as long, even if it’s the same $150,000 lump sum need.
In fact, the recent Vanguard/Mercer study on retiree health care expenses emphasizes how health-related factors are really the primary driver of planning for health care expenses in retirement. Because health care expenses themselves are not evenly distributed across all retirees—common chronic conditions, including hypertension, high cholesterol, arthritis, heart disease, diabetes, kidney disease, depression, Alzheimer’s, and dementia among others, actually drive the overwhelming bulk of total retiree health care costs.
For instance, the Vanguard/Mercer model simply separates retirees into low-, medium-, or high-risk categories based on whether they have no chronic conditions, 1 chronic condition, or 2+ chronic conditions and/or are smokers. And on this basis alone, not only is there a substantial difference in the median annual health care, but there is an even more drastic range—a whopping $21,000/year—for those with the highest health risks.
The Impact Of Medicare Premium Surcharges (IRMAA) On Annual Retiree Health Care Costs
In addition to the sheer variability of out-of-pocket expenses driven by various chronic health conditions in retirement, income-based adjustments to Medicare insurance premiums for higher-income individuals can also have a substantial impact. Because Medicare Part B, along with Part D prescription drug coverage, and Medigap supplemental policies, are all guaranteed issue (i.e., not restricted or priced differently based on health conditions), both Medicare Part B and Part D premiums are also impacted by income levels themselves, thanks to the so-called “Income-Related Monthly Adjustment Amount” (IRMAA) rules.
Specifically, the IRMAA rules state that once Adjusted Gross Income exceeds $85,000, there is a roughly $600/year/person increase in Medicare Part B premiums, and another $150/year/person increase in Medicare Part D premiums. And that surcharge amount continues to rise as income rises, capping out at an additional surcharge of nearly $5,000/year/person in 2019!
As a result of these Medicare premium surcharges, the total annual health care cost for an individual can be substantially higher, simply because of the surcharges layered on top of the remaining premiums and potential out-of-pocket expenses.
The Health Care Cost Complications Of Retiring Early
While the data of the Vanguard/Mercer study shows that health care costs are actually rather stable and feasible to plan for on an annual basis, thanks to Medicare, the matter is far more complicated for those who are retiring ‘early’ (i.e., before they become eligible for Medicare at age 65).
Over the past several decades, health insurance has evolved to provide a continuous flow of coverage, from children covered by their parents’ plans during their early years, to obtaining their own employer coverage once they were able to work for themselves, culminating in Medicare at age 65 when they were no longer able to work anymore. But that left a gap for those who did not work and lost access to employer-based coverage, for which individually-purchased policies were not always available.
The good news is that, since the rollout of the Affordable Care Act, “early” pre-age-65 retirees do at least have one option assured to access health insurance: state health insurance exchanges. Available either during an open enrollment period, or immediately following the termination of employer coverage, health insurance exchanges mean that early retirees will at least know that they can obtain health insurance in the marketplace and without the risk of being declined or facing exclusions for pre-existing health conditions. In practice, this means that insurance coverage during the working-age years is a combination of employer coverage for those who are working, and state insurance exchanges as a backstop for those who don’t have employer coverage.
However, the Vanguard/Mercer study does estimate that the median cost of a Silver plan on the exchange for a pre-Medicare 64-year-old is $8,000/year, as contrasted with an average cost of $5,700/year for a Silver plan for a 40-year-old, and a net cost of just $1,300/year for the typical employer plan. And a Silver plan for an early retiree is also substantially higher than the roughly $3,600/year cost of premiums for Medicare Part B, Part D prescription drug coverage, and Medigap Plan F coverage.
At a minimum, this means that ‘early’ pre-age-65 health insurance many be available and ‘plannable,’ but retirees planning for health insurance costs in early retirement need to plan for the bump in annual premiums after employer group health insurance ends, but before Medicare begins. That in turn introduces additional planning strategies to manage those premiums by drawing on Premium Assistance Tax Credits, that may be available for individuals with income up to $48,240, or married couples up to $64,960.
Integrating Retiree Health Care Costs With The Rest Of The Plan
Given both the fact that these expenses are specific to the individual, and that medical expenses inflate higher than the general rate of inflation, arguably health care costs should be projected separately from the remainder of retiree expenses. Out-of-pocket expenses for health care also tend to rise over time, simply because retirees tend to have more health events as they get older.
Notably, though, retirement researchers have found that other more discretionary spending in retirement tends to decline in later years, even as health care expenses disproportionately rise. In fact, the Vanguard/Mercer study notes that average spending on health care rises almost 36% from age 55-64-year-old retirees to those who are age 75+, while other spending falls by 29% over the same time period. Except given that health care expenses are ultimately still only a moderate slice of a retiree’s total budget, health care expenses rise “just” $1,116/year, while overall spending falls by $10,498. Which means even if/when/as health care expenses rise in the later years’ of retirement, it’s more than offset by other retirement spending decreases anyway!
In other words, a key aspect of the Vanguard/Mercer study is that in the end, retirees may be far more distressed about health care expenses than the actual risks they face, both because medical expenses in retirement are actually far more stable than most realize thanks to the availability of Medicare plus Medigap insurance (except, perhaps, for a small subset of the highest risk retirees with multiple chronic conditions who at least face some upside out-of-pocket cost risk), and because discretionary spending tends to naturally decline by far more than health care expenses rise in the later years of retirement.
This article is excerpted from a longer piece by Michael Kitces, which can be read in its entirety here.