Kitces: Are retiree health care costs overblown?

The average 65-year-old couple will need a whopping $280,000 just to cover their health care costs in retirement, not including long-term care needs, according to a recent study by Fidelity.

Yet the reality is that health care costs aren’t borne as a lump sum on the day of retirement. And though individual health care costs may vary, they do so in rather predictable and plannable ways.

This perception gap presents yet another case where advisors can add value to the client relationship, not only by helping quell nerves, but by taking proactive steps to plan for potential health care costs — something that, as recent research suggest, we can do with a surprisingly high level of confidence.

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 wasn’t actually running out of money before the end of retirement, but rather how they’re going to handle health care costs in retirement.

That fear isn’t necessarily surprising, given annual studies showing how substantial health care costs in retirement can be. A couple retiring today needs a whopping $273,000 to have a 90% chance of covering their health care costs, including Medicare, Medigap supplemental insurance coverage and out-of-pocket spending, whether it’s prescription drug co-pays or hospital coinsurance, according to a recent study by the Employee Benefits Research Institute. As previously mentioned, Fidelity similarly estimates the cost at $280,000.

Yet, while these dollar amounts may seem eye-popping — especially given a recent TransAmerica study’s findings that the average boomer has saved just $147,000 for retirement — it turns out that the typical savings requirements for retiree health care costs are really little more than a moderate ongoing dollar amount, albeit one spent repeatedly over a multi-decade period.

For a typical 65-year-old woman, the median annual health care expense in retirement is just $5,200 per year, according to a recent joint study between Vanguard and Mercer Health and Benefits. Of course, that expense may continue for 20-plus years, adding up to more than $100,000, plus ongoing health care inflation at a rate above the general level of inflation.

And for a married couple, a spouse may incur another $5,000-plus per year between $1,600 per year in Medicare Part B premiums, $600 per year in Part D prescription drug coverage, another $1,700 in comprehensive annual Medigap Part F and $1,100-plus annually in various out-of-pocket costs.

Yet ultimately, recognizing that health care costs may be just about $5,000 per year per person — or $10,000 per year for a couple — for 20-plus years of retirement is not necessarily as daunting as a $273,000-plus lump sum obligation.

After all, as the Vanguard/Mercer study notes, the Bureau of Labor Statistics Consumer Expenditure Survey data estimates that the average individual over age 65 spends $16,903 per year on food, clothing and shelter in retirement, but we don’t typically report this as a $400,000 lump sum obligation. And in fact, BLS data shows that total spending over age 65 in all categories is nearly $31,000 per year — which again isn’t typically reported as a $740,000 lump sum requirement.

Similarly, most retirees don’t look at their income streams in retirement as lump sum assets either. Yet the lump sum value of the average $1,294 monthly Social Security benefit is nearly $280,000 for males and $335,000 for females, an over $600,000 for married couples. Meanwhile, couples who each earned the maximum Social Security benefit have a combined Social Security lump sum value of over $1.1 million.

In other words, any moderate dollar amount of several thousand dollars per year, repeated for a multi-decade period of time, seems like a really big number. Yet in the case of health care expenses it’s actually not that big, especially when considering retirement savings that can grow over time to support it, as well as other illiquid but sizable income resources such as Social Security.

Stated more simply, in a world where most households spend the better part of 40 years managing household cash flow to a monthly cadence of paychecks and bills, it may simply be more appropriate to think about and plan for health care expenses in retirement as just another line-item expense.

The other reason why it’s so important to project health care expenses in retirement as ongoing expenses, rather than a lump sum, is that just looking at the latter would confuse two key factors that drive cumulative health care costs.

The first major factor is longevity. The longer a retiree lives, the larger the cumulative cost of health care. Spending $5,000 per year for 30 years requires $150,000, assuming the growth rate on assets matches the rate of health care inflation. A retiree who lives only 15 years requires half that amount, or $75,000.

The second major factor is the amount per year of any particular retiree’s health care expenses, which will be impacted heavily by his/her health status and the existence of any chronic conditions. For instance, an unhealthy individual with a 15-year life expectancy who spends $10,000 per 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 per year with an anticipated 30 year retirement spending horizon.

But in practice, an unhealthy individual planning $10,000 per year for a limited period has very different planning needs that may necessitate different cash flow trade-offs and insurance decisions than one planning for a healthy, $5,000-per-year need for a multi-decade time horizon.

In fact, the Vanguard/Mercer study emphasizes how health-related factors are really the primary driver of planning for health care expenses in retirement, because those expenses are not evenly distributed across all retirees. Instead, a subset with one or several of the most common chronic conditions — including hypertension, high cholesterol, arthritis, heart disease, diabetes, kidney disease, depression, Alzheimer’s and dementia, chronic obstructive pulmonary disease (COPD), cancer, asthma and osteoporosis — actually drive the overwhelming bulk of total retiree health care costs.

To further illustrate this point, an analysis of Medicare claims from the Centers for Medicare and Medicaid Services (CMS) found that the average Medicare spending for healthy retirees — i.e., those without any or just one chronic condition — is just over $2,000 per year, but the amount more than doubles to nearly $5,700 for those with two to three chronic conditions, and is six times that amount for retirees with four to five chronic conditions. For the subset of retirees on Medicare with six-plus chronic conditions, the multiplier factor increases from six to 16.

In other words, understanding whether or how many chronic conditions a retiree has — which is generally known at the retirement transition, as most, though not all, such conditions have presented themselves by the time an individual is in their 50s or 60s — provides substantial additional information about the realistic trajectory of health care costs in retirement, as well as the potential for unusually large expenditures.

For instance, the Vanguard/Mercer model simply separates retirees into low-, medium- or high-risk categories based on their number of chronic conditions and whether they are smokers. On this basis alone, not only is there a substantial difference in median annual health care costs — from $3,400 per year for low-risk individuals to more than double that amount, at $7,600, for high-risk retirees —there is an even more drastic range within the upper 90^th percentile at $4,300 per year for low-risk individuals, $6,600 per year for medium-risk retirees and a whopping $21,000 per year for those with the highest risk profiles.

MEASURING COST IMPACTS
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.

As while Medicare Part D prescription drug coverage and Medigap supplemental policies are guaranteed issue — at least for those who enroll when first eligible — with a relatively narrow band of pricing that changes primarily based on geography and the available drugs in the formulary for Part D plans, Medicare Part B premiums are also impacted by income levels themselves thanks to the so-called Income-Related Monthly Adjustment Amount (IRMAA) rules.

Specifically, the IRMAA rules stipulate that once Adjusted Gross Income from the prior-prior year exceeds $85,000 for individuals or $170,000 for married couples, there is roughly a $600 per year per person increase in Medicare Part B premiums on top of the base annual premium of $134 per month, or about $1,600 per year. On top of that, there’s another increase of $150 per year per person 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 per year per person in 2019 for those with more than $500,000 per year of income as individuals, or $750,000 per year for married couples.

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. When this is coupled with health risks and geographic variability, it can produce a very wide range of potential annual health care costs, especially for those with a greater number of existing chronic health conditions.

RETIRING EARLY
While the data of the Vanguard/Mercer study shows that health care costs are actually rather stable, thereby making it feasible to plan for thanks to Medicare — albeit with a little more volatility for those at the highest levels of health risk — 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 on 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 presumably were not working anymore. That was fine for those who worked until age 65, but it left a gap among those who did not work — or chose not to — and lost access to employer-based coverage, for which individually purchased policies were not always available due to limitations on pre-existing conditions or individual underwriting that made coverage unaffordable for those who needed it the most.

The good news is that since the rollout of the Affordable Care Act, pre-age-65 retirees do at least have one assured route to health insurance: state-administered 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 — or explicitly higher premiums due to — pre-existing health conditions.

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 lack employer coverage.

The caveat is that while the state insurance marketplaces ensure available coverage, it’s still necessary to pay for that coverage. And while the marketplace premiums cannot be priced higher based on an early retiree’s individual health conditions, the cost of coverage is based on age, which can make it quite expensive to purchase for near-retirees in their late 50s and early 60s, especially relative to the typical cost of employer-based coverage.

For instance, the Vanguard/Mercer study estimates that the median cost of a Silver plan on the exchange for a pre-Medicare 64-year-old is $8,000 per year, as contrasted with an average cost of $5,700 per year for a Silver plan for a 40-year-old, and a net cost of just $1,300 per year for the typical employer plan — presuming the latter is offered by a large corporation that provides health insurance to its employees. And a Silver plan for an early retiree is also priced substantially higher than the roughly $3,600 annual cost of premiums for Medicare Part B, Part D prescription drug coverage and Medigap Plan F coverage.

And of course, all of these plans also have additional out-of-pocket costs beyond the health insurance premiums, which also tend to be higher for state-insurance-exchange–based policies than either Medicare or employer coverage, amplifying the gap even further — especially for those with existing chronic health conditions.

This means that at a minimum, pre-age-65 retirees planning for health insurance costs in retirement need to plan for the bump in annual premiums and additional out-of-pocket costs after employer-subsidized employer group health insurance ends and when Medicare begins. This 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.

MAINTAINING THE PLAN
Health care costs in retirement are just one of many expenses that retirees face, and not even necessarily the biggest.

Nonetheless, given these expenses are specific to the individual, may vary over time —especially for those who retire before age 65 and then later transition to Medicare — and inflate at their own, higher-than-the-general-rate-of inflation (3.6% vs. 2.2%, respectively, over the past 20 years), health care costs should really be projected separately from the remainder of retiree expenses in analyzing a retirement plan.

That’s saying nothing for that fact that out-of-pocket expenses for health care also tend to rise over time, simply because retirees tend to experience more health events as they get older — in addition to the fact that those expenses are rising at a higher rate of inflation.

All that said, retirement researchers have found that 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 compared to the 55-to-64-year-old retiree cohort, average spending on health care rises almost 36% after reaching 75. Meanwhile, other spending falls by 29% over the same time period, and tends to fall even further in a retiree’s 80s.

But given that health care expenses are ultimately just a moderate slice of a retiree’s total budget, in the end they rise just $1,116 per year, from $3,046 to $4,162, while overall spending falls by $10,498, from $35,825 to $25,327. This means that even when health care expenses rise in the later years’ of retirement, it’s more than offset by other retirement spending decreases.

Consequently, retirees may be far more distressed about health care expenses than the actual risks they face. Of course this still doesn’t address the potential risks of needing long-term care in particular, but as Vanguard emphasizes, those needs are actually separate and distinct from health care expenses in retirement, both because long-term care needs can ultimately be much larger — with an estimated 15% of retirees facing a greater-than-$250,000 expense — but are also far more likely to be non-existent, with 48% of retirees experiencing no long-term care expenses at all, and another 25% needing less than $100,000 in total.

This suggests that long term care insurance should be especially appealing to further stabilize this risk, converting it from an unlikely but potentially very sizable unknown expense into a stable and known — albeit not inexpensive — insurance premium. That’s especially true if the long term care insurance industry can develop better, alternative high-deductible LTCI options.

PLANNING FOR COSTS
The good news is that when the costs of health care in retirement are known and relatively stable, it is feasible to actually plan for them. This can be done via simply saving to cover the costs; leveraging savings for retiree health care expenses with an HSA; planning to maximize Premium Assistance Tax Credits to the extent feasible during the years of state marketplace coverage before Medicare begins; and making good, proactive planning decisions about Medicare enrollment itself — particularly with respect to selecting the best Part D prescription drug plan based on current medication needs, and choosing the right Medigap supplemental policy to further balance between higher premiums and lower out-of-pocket cost exposure.

Still though, as Vanguard notes in its study, planning for annual health care costs in retirement requires some real planning. It extends from selecting the right type of coverage to considering the health of the retiree and any known chronic conditions that can most materially impact costs over time, to simply planning for the changes to household cash flow that occur in the transition from employer-based coverage to either Medicare or exchange-based coverage prior to age 65.

The fundamental point, however, is that health care costs in retirement shouldn’t be thought of as a lump sum obligation. Using resources like the Vanguard/Mercer study, health care expenses can and should simply be treated in the planning relationship as an ongoing cost, just like virtually any other expense.