How should you really evaluate retirement health care costs?

A crucial part of retirement income planning is helping you estimate health care expenses in retirement, both in the first year of retirement and over a your life expectancy. These costs are notoriously difficult to estimate because they depend on: 1) a client’s health care usage (i.e., health status) both now and in the future; 2) the rate at which health care costs will escalate in the future (inflation); and 3) how long a client is expected to live (life expectancy). And then there’s long-term care—or not.

Vanguard and Mercer recently teamed up to produce a report, Planning for Health Care Costs in Retirement, that helps to refine this exercise. Rather than lumping everyone into one big pot and basing estimates on statistical averages, it breaks down costs based on the following factors:

  • Health status and risk
  • Medicare coverage choices
  • Retirement age
  • Employer subsidies
  • Geography
  • Medicare surcharges

To begin with, the report eschews the idea of quoting health care costs in terms of lifetime expenses, such as the $280,000 that Fidelity says a 65-year-old couple will need at the start of retirement to cover health care. “Framing annual health care costs as a large lump sum is behaviorally distracting and fails to highlight the essential factors associated with planning for these annual costs,” the report says. (bold in this article are my emphasis)Think about it: the average one-person household spends $16,903 per year on food, clothing, and shelter combined. This cost seems reasonable. But if it’s converted to a lump sum estimate with inflation over a 24-year time horizon, it translates to over $400,000. When clients are planning for retirement, they are inclined to think in terms of monthly or annual expenses for the various budget categories. Health care is one of those categories that should be expressed in monthly or annual terms with an annual inflation factor of around 5%. To convert this one budget category to a lump sum over life expectancy skews the whole retirement income planning exercise. [Another example: What insights would you have knowing how much you would spend, as a total lump sum today, over your remaining lifetime at Starbucks? Would that help you plan your retirement better? It’s the same for any expense in retirement.]

Also, the report separates out long-term care and considers it apart from regular health care expenses. This is because of the wide variation long-term care usage. Nearly half of all retirees will never need long-term care and will spend $0 on its costs. At the other extreme are the 15% of retirees who will pay over $250,000. Long-term care expenses will vary depending on a client’s condition (Alzheimer’s is the most common reason to need long-term care), where they live (northeast is most expensive), and which resources will be utilized to pay for it (LTC insurance, Medicaid, or personal assets). There are no quick and easy answers to the question of how to estimate long-term care costs, but the report does offer several ideas on how to plan for it (see page 20 of the report.

As for estimating annual health care costs, of the six factors noted above, most influential is health status and risk, particularly the presence or absence of one or more of 12 chronic conditions: hypertension, high cholesterol, arthritis, heart disease, diabetes, kidney disease, depression, Alzheimer’s, COPD, cancer, asthma, and osteoporosis. Notably, if one of these conditions is going to show up, it likely will do so by one’s 50s or 60s.

Based on the presence or absence of these chronic conditions, along with smoker status and number of doctor visits in the last year, risk status is established as low, medium or high. Typically, high-risk people are smokers, visit the doctor regularly, and have two or more chronic conditions. Their spending on health care is in the top quartile. Low-risk individuals are free of chronic conditions and spend in the bottom quartile. Spending for medium-risk individuals is in the two middle quartiles.

The median annual expense for a 65-year-old woman with Traditional Medicare plus a Part D drug plan (but no supplemental insurance), including premiums and out-of-pocket costs, was $3,400 if she was low risk (ranging from $3,200 to $4,300), $3,900 if she was medium risk (ranging from $3,400 to $6,600), and $7,600 if she was high risk (ranging from $4,600 to $21,000). [See Figure 1 below].

Figure 1. Median annual health care costs vary widely by individual health risk category

 

Source: Mercer-Vanguard health care cost model, 2018.

(Please click image to enlarge)

Adding supplemental insurance [Medigap policies] in the form of Medigap Plan F raised the median cost to $5,200 from $3,900 if she was medium risk, and lowered it to $6,500 from $7,600 if she was high risk. [Plan N also depicted with Plan F in Figure 2].

Figure 2. Total health care costs under different Medicare coverage options vary by health status

Source: Mercer-Vanguard health care cost model, 2018.

(Please click on image to enlarge)

They didn’t show what the effect of supplemental insurance would have on the low-risk individual, but it’s probably not much different from that of the medium-risk person. The upshot: for low-and medium-risk individuals, health care costs are higher when you have supplemental insurance. Premiums alone account for $3,600 of the $5,200 in total expenses. Under Traditional Medicare with no supplemental insurance, premiums total $1,800 and the median total cost is $3,800. This is $1,400, or 27% lower. Per year. [However, the reason to have supplemental insurance is for those catastrophic health events you don’t expect. Much like homeowner’s insurance, you don’t expect your house to burn down. You don’t really know what health events you may have in the future, based on your risk now.]

 

[Moral of the story: First, lifetime calculations of any living expense is a fruitless exercise that doesn’t help much. Rather, annual expense calculations bear more insight and allow a more direct calculation of how much, in total, you should have at retirement as well as each year in retirement, to support all those annual expenses in future expected years throughout retirement. Then, having more insight into what risk category you may be in (from above) and what Medicare plan you may need based on your usage of health care, helps refine your expenses individually. Finally, couple may be in different categories so each one should evaluate their situations separately, and then that total used for their combined annual retirement expense in the medical category.]

 

Article first appeared in an adviser newsletter, 28 Jun 18, “Study sheds new light on health care costs in retirement” by Elaine Floyd, CFP®, Director, Retirement and Life Planning, Horsesmouth, LLC. My thanks to her. I edited the article for the public. Bold (emphasis) and added comments [brackets] are mine. I also added various links for additional information.

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