Reducing Employee Panic About Health Costs in Retirement

Separating the amount of premiums and out-of-pocket expenses can help employees see more realistic expenses to plan for than a huge lump-sum number.

Those planning for retirement have anxiety about future health care costs. It’s understandable when estimates are provided for a total amount of costs during retirement—Fidelity estimates a 65-year old couple retiring in 2019 can expect to spend $285,000 in health care and medical expenses throughout retirement.

But, a report from T. Rowe Price contends it’s more practical to look at health care as an annual expense incurred over 20 to 30 years than as a lump sum. “For example, a couple might spend a total of $86,000 for cable TV in retirement. But when budgeting, they’d consider it a monthly expense of about $150, not a single large payment. The same holds true for health care,” says Sudipto Banerjee, Ph.D., senior manager, thought leadership, T. Rowe Price, in the analysis.

He says lump-sum estimates are not very helpful for individual retirement planning. “There are embedded health insurance coverage assumptions in most of these calculations. Health insurance coverage varies significantly for retired Americans, even under the broad umbrella of Medicare. It is not clear if any particular type of health insurance coverage can be termed as ‘typical,’” Banerjee says.

Premiums are relatively stable at the individual level, but out-of-pocket costs are more uncertain and, as a result, account for most of the variation in health care expense projections. The article notes that premiums also constitute the bulk of their health care expenses for the majority of retirees—about 75%. “As a result, for most retirees, a large chunk of their annual health care costs is predictable and can be easily planned for, a fact masked by the combined lifetime health care cost estimates,” Banerjee states.

He points out that it is hard to build a financial plan around a lump sum since health care expenses are not incurred as a lump sum, and it is not clear how such information can be used to plan for retirement health care costs. Using the example of a hypothetical 65-year-old couple who needs $300,000 to fund their health care costs in retirement, he queries, “How should they go about it? Should they set aside $300,000 from their retirement savings at age 65 to meet their future health care cost needs? If so, how should they allocate the sum between savings and investments? And what if they only have $280,000 in retirement savings? Does that mean they have no chance of affording their projected health care expenses? And if they should not set aside the $300,000 as a lump sum, how much do they need at age 65, 75, or 85?”

The article suggests framing health care costs in retirement should be based on (at least) three factors: Annual costs; type of health insurance coverage; and separation of premiums and out-of-pocket expenses. “Premiums, similar to other monthly expenses, like a cable or utility bill, are often paid from monthly income. On the other hand, out-of-pocket expenses are much more likely to be funded from savings,” Banerjee says.

He notes there are a host of other factors (income, age, health status, marital status, state of residence, etc.) that can be added to personalize the planning experience for individuals. But, since it is not always possible to reliably estimate retiree health care costs using all these factors, the three-factor approach is a reasonable basic framework to estimate health care costs in retirement.

“If premiums are a fixed month-to-month expense item, they are no different than rent or a cable bill. So, like those other items, premiums should also be funded from the regular stream of monthly income. Doing this helps retirees form a more accurate monthly budget, which in turn helps to create a better income plan,” Banerjee suggests.

On the other hand, non-routine out-of-pocket health care expenses are likely to be funded from a pool of liquid assets (savings). “A realistic estimate of such expenses could help retirees to plan how much in liquid assets they should hold at any point in time to meet their health care cost needs,” Banerjee says. “We suggest maintaining a liquid fund, like a savings account, with enough money to meet out-of-pocket expenses. Replenished annually, this fund can help retirees cope with out-of-pocket uncertainties.”

The huge numbers often reported are usually skewed by an unfortunate few who pay very high expenses over a long period, but that won’t be the case for most retirees, he points out. His study found half of retirees who have traditional Medicare (Parts A and B), a prescription drug plan (Part D) and Medigap will spend less than $1,110 a year on out-of-pocket expenses. Only one in 10 will likely spend more than $4,500, and, and it’s unlikely they’ll keep paying that much over the rest of their lifetime.

Employers and advisers can replace employees’ panic with a prudent plan. Start by presenting health care expenses rationally, as a combination of predictable monthly expenses (insurance premiums) that can be budgeted for, and less predictable expenses (out-of-pocket) that can be managed from savings, Banerjee suggests. Next, emphasize careful consideration of Medicare options, comparing premiums, coverage and out-of-pocket expenses. Finally, suggest keeping a liquid cash reserve to help cover unpredictable expenses, replenishing it each year based on the previous year’s expenditures.

The report, “A New Way to Calculate Retirement Health Care Costs,” may be downloaded from here.