For many, health insurance and health care services are likely to be among the largest expenses in retirement. The fact that health care costs continue to rise faster than the rate of overall inflation can be a source of concern for retirees and those contemplating retirement. Furthermore, unlike other non-discretionary costs during retirement, health care spending is ultimately a wild card, as it is obviously hard to forecast how long you will live and what the quality of your health will be as you age.
The purpose of this newsletter is to add some perspective to this often-daunting topic, as well as to outline a few concrete steps you can take to help mitigate health care risk. For those on the verge of retirement, we’ll also address how we can help you by incorporating the potential cost of health care into a well-formulated financial/retirement plan, and then stress-testing it.
First, let’s take a broad view of the estimated amount of savings needed, on average, to cover health care costs in retirement. One oft-cited source is a study that is updated annually by the Employee Benefit Research Institute (EBRI). It estimates the savings needed to cover out-of-pocket costs not covered by Medicare (in other words, Medigap insurance premiums, Medicare Part B premiums, Medicare Part D prescription drug plan premiums, and out-of-pocket drug expenses).
According to EBRI’s most recent 2015 study, a 65-year-old man needs, in today’s dollars, $68,000 in savings, and a 65-year-old woman needs $89,000, to give each a 50% chance of having enough money saved to cover health care expenses in retirement.1 To give each a 90% chance of having enough savings, the amounts are $124,000 for a man and $140,000 for a woman.
Of course, individual costs can vary significantly due to differences in personal health, location, and insurance coverage. Moreover, the figures above assume median prescription drug expenses. For those in the 90th percentile (that is, the top 10% tier) of drug expenses, the savings required for a 90% chance of success increase to $188,000 for a man and $212,000 for a woman. And finally, EBRI’s analysis does not factor in the savings needed to cover long-term care expenses, which can be another major concern for retirees (we address these expenses later).
But Other Costs May Go Down
While these figures, and the wide range of possible ultimate outcomes for any one individual or couple, can be unnerving, it’s important to bear in mind the bigger picture: Although health care expenses may consume a larger share of total spending, particularly later in retirement, overall spending tends to decline.
More specifically, some expenses typically disappear during retirement; some vanish immediately, while others tend to diminish over time. A few examples include retirement account contributions, payroll taxes (Social Security taxes cost workers 6.2% of their pay, up to $118,500 in 2016, and Medicare taxes are 1.45% of wages, with no limit), commuting costs, life insurance premiums, possibly one’s mortgage payment, and family expenses (namely, feeding, clothing, and transporting family members beyond you and your spouse).
Indeed, according to the most recent Consumer Expenditure Survey of the Bureau of Labor Statistics, average U.S. household spending peaks at age 45. After that age, spending declines in all categories but two—health care and charitable contributions and gifts. Among the categories with the most dramatic reductions in spending are apparel and services (spending in this category declines almost by half by age 80), transportation, and mortgage payments.
These findings are illustrated in this chart from J.P. Morgan Asset Management, which breaks out expenses by type for the average household over time.
In fact, using data based on Chase credit card, debit card, and mortgage payments, J.P. Morgan observed that spending patterns at older ages appear to hold across wealth levels, with only minor variations, even at various levels above $1 million in investable assets.2
Some Steps You Can Take
With all of this said, there are several ways to curb retirement health care costs, beyond the obvious ones of establishing good health habits and saving more. A few examples are:
Health savings accounts (HSAs): HSAs allow you to put aside money for qualified medical expenses and save on taxes at the same time. Contributions to an HSA are deductible for federal taxes; earnings and withdrawals are also exempt from federal taxes.3 Distributions that aren’t used to pay medical expenses are taxed as gross income and will be subject to an additional 10% federal penalty tax until you reach age 65.
To be eligible to open an HSA, you must be covered under a high-deductible health plan (in 2016, the criterion is a deductible of at least $1,300 for single coverage or $2,600 for family coverage). In addition, you can’t be covered by any other health plan, entitled to Medicare benefits, or claimed as a dependent on another person’s tax return. The contribution thresholds for 2016 are $3,350 for single coverage or $6,750 for family coverage, plus an additional $1,000 “catch-up” contribution if you’re age 55 or older.
Given these thresholds, HSAs are most beneficial for younger investors who have more time to accumulate savings before retirement. To optimize the tax benefits, one should consider paying for current medical expenses with cash and letting the funds in the HSA continue to compound tax-free until retirement.
HSAs are typically offered by banks and credit unions, as opposed to brokerage firms like Fidelity (our firm’s dedicated broker). Therefore, we cannot manage these for our clients; however, we can assist as an information source and sounding board.
Mind your MAGI: For those who are already receiving, or who will shortly receive, Medicare benefits, it can be beneficial to minimize one’s modified adjusted gross income, or MAGI (adjusted gross income plus any tax-exempt interest) to the extent possible. This is because Medicare Part B and Part D premiums are means-tested; if MAGI exceeds $85,000 for singles or $170,000 for married couples, premium surcharges apply. Furthermore, MAGI brackets will be condensed starting in 2018, so more people will pay a higher surcharge. And because there is a two-year lag between the latest available tax data and Medicare premiums, 2018 MAGI brackets (which determine 2018 Medicare premiums) will be based on 2016 income.
So what are some steps retirees can take to keep their income under the aforementioned thresholds—or at least at one of the lower of the four premium rungs?
First, withdrawals from a Roth IRA, a Roth 401(k), or an HSA are not included in your MAGI. Thus, particularly with regard to Roth accounts, it may be worth funding these when possible during your working years, even if you’re in a relatively high tax bracket, as this “tax bucket diversification” may provide some flexibility during retirement.
Another way to minimize your MAGI, assuming your overall resources are sufficient, is to donate all or part of your required IRA minimum distribution to charity. Those aged 70½ and older can now transfer up to $100,000 annually from their IRAs to charity (this provision was recently made permanent by Congress).
Finally, if you incur a surcharge after you retire, you may be able to reduce it. Again, there is a two-year lag between the most current available tax data and Medicare premiums; thus, the premium for a retiree starting Medicare in 2016 would be based on 2014 income. You may be able to contest a surcharge due to a “life-changing event”—which includes retirement—and ask Social Security to use your more recent income instead as the basis for your Medicare premiums.
Shop around: Recent studies have found that premiums for identical coverage for the same person can vary by 100%. For instance, there are people paying twice as much for Medicare Part D prescription drug coverage and Medigap policies as they should because they didn’t shop around.4
Beneficiaries should take advantage of the annual Medicare open enrollment period, which starts in mid-October each year. Medicare’s website contains useful information, including an online plan shopper. Another resource is the State Health Insurance Assistance Program (SHIP), a federally funded program that provides free local health coverage counseling to people with Medicare. Indeed, we featured a local SHIP organization in a prior recorded webinar.
How About Long-Term Care?
The risk of needing long-term care is another major retirement planning concern. This topic alone—and, more specifically, long-term care insurance (LTC)—could easily warrant its own newsletter. In large part, that’s because LTC has been subject to much debate, given that it can be notoriously complex and expensive. Indeed, many carriers have dropped out of the market over the past several years, leading to skyrocketing premiums even for many existing policyholders.
Historically, we have struggled to advocate LTC for the vast majority of clients, from a purely financial—as opposed to peace-of-mind—perspective. Many would likely concur that our typical high-net-worth client can afford to “self-insure” (that is, pay for extended care out of their own resources). In addition to liquid assets, many of our clients have significant equity built up in their homes (particularly here in the Bay Area) that potentially could be tapped to help pay for care. Moreover, as we discussed earlier, other significant expenses may decline in tandem when the need for long-term care arises; for many of our clients, this would include big-ticket discretionary items like travel.
Furthermore, despite the insurance industry often promoting LTC as a “must have,” one should bear in mind that insurers expect to make a profit. Or, stated differently, buying insurance is, on average, expected to be a losing proposition from a financial perspective, as insurers expect to pay out less than their customers pay in premiums. And when it comes to LTC, these premiums are not inexpensive.
Finally, a recent and frequently cited study from Boston College’s Center for Retirement Research further complicates the buying decision. It concluded that previous academic research understated the risk of going into a nursing home but overstated the average length, and consequently the cost, of those stays. Specifically, the study found that, of those who do spend time in an assisted care facility, 50% of men and 40% of women stay 100 days or less. Thus, for a good percentage of the population, an LTC policy may never kick in, as Medicare covers the full cost of care in a skilled nursing facility for 20 days and partial costs thereafter, up to 100 days.5
We Can Help
Whether you are evaluating possible funding options for long-term care or determining how to factor health care costs into your retirement plan, we have many years of experience tackling these issues for clients. And while health care costs may be the most difficult retirement expense to predict, we have invested in robust, ever-improving financial planning software that can model these line items. This includes forecasting Medicare premiums, if need be, based on one’s MAGI, incorporating a specific inflation rate assumption for overall health care expenses, and performing a long-term care needs analysis.
Of course, any model is only as good as its input and assumptions. But with our experience and informed judgement, we can help put a plan in place to help you manage your health care expense burden, and thus hopefully lighten the load for a more comfortable retirement.
1. Fronstin, Salisbury, VanDerhei, “Amount of Savings Needed for Health Expenses for People Eligible for Medicare,” EBRI, October 2015.
2. Carson, McGrath, “Health Care Costs in Retirement,” J.P. Morgan Asset Management, September 2015.
3. States can choose to follow federal tax treatment guidelines for HSAs or establish their own. Although most follow federal tax guidelines, California does not.
4. Carlson, “The New Rules of Retirement,” Retirement Watch, 2015.
5. Fronstin, Salisbury, VanDerhei, “Amount of Savings Needed for Health Expenses for People Eligible for Medicare,” EBRI, October 2015.