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How Health Care Will Crush the 80% Income Replacement Idea in Retirement

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How much income does a retiree need to live a happy and healthy life? That’s a key question for financial advisors and their clients, and for many years, the answer has been between 80% and 85% of pre-retirement income.

Some experts like Michael Finke, coordinator of the doctoral program in personal financial planning at Texas Tech University, say that an 80% to 85% income replacement ratio, as it is known, is too high because, among other things, retirees spend less on transportation and no longer pay a 7.5% FICA tax for Social Security – if they were employees – or a 15% FICA tax, if they were self-employed. But Ron Mastrogiovanni, the co-founder and CEO of HealthView Services, which provides health care cost projections for financial services companies, says that ratio may be too low.

The firm’s latest HealthView Insights report, “Retirement Health Care Costs and Income Replacement Ratio,” notes that even those in the $250,000 income bracket may need to replace a larger share of their income for two big reasons: First, health care expenditures in retirement will be much greater than those expenses before retirement. In addition, health care inflation is running at about 6% annually, twice the average historical inflation rate.

“The stark reality is that health care is going to cost more than most retirees have saved using traditional IRR-based plans,” according to the report.

Not only are retirees likely to have more health issues than they had before retirement, but they will also be responsible for a larger portion of those costs despite Medicare. “Retirees are responsible for almost 100% of their health care costs,” [but] “IRR calculations use the same 25% figure that employees contribute for health care premiums,” according to the report. Employers pick up the other 75%.

Retirees will be paying premiums for Medicare Part B, which covers doctors’ services and outpatient care; Medicare Part D, for prescription drugs; and Medicare gap coverage, also known as supplemental insurance, which covers the copayments, coinsurance and deductibles that Medicare doesn’t pay.

That could cost retirees about triple what they paid for similar coverage as employees, according to HealthView Services: about $3,500 compared with roughly $1,200 for an HMO or $1,300 for a PPO plan (preferred provider) they contributed to as employees. There’s also no cap on out-of-pocket health care expenses for retirees as there is for most employees’ health care plans.

In addition, retirees with modified adjust gross incomes (MAGI) above $85,000 (for singles) or $170,000 (for couples filing jointly) are subject to separate surcharges for Medicare Parts B and D, the report notes. That could increase premiums for Medicare Parts B and D anywhere from 37% to over 200%, according to the report. This surcharge is separate from the 3.8% Medicare surtax that individuals with MAGI above $200,000 for individuals or $250,000 for couples have to pay as part of the Affordable Care Act.

Health Care Costs in Retirement for Singles. Source: HealthView Services

So what percentage of income should a person put away to finance their retirement after accounting for higher health care costs?

“There is no rule of thumb,” says Mastrogiovanni. “But if you’ve been saving the income replacement ratio you won’t cover all your health care costs.”

A 55-year-old retiring at age 65 with a life expectancy of 86, for example, will be responsible for about $390,000 in retirement health care costs, according to the HealthView Insights report. Depending on how much he has already saved, he may need to either contribute more to a retirement account or make a lump-sum payment, or both, according to the report.

Another thing to consider, says Mastrogiovanni, is whether a client will be subject to Medicare surcharges, which are not indexed to inflation. Even if a client’s income at age 65, when he or she qualifies for Medicare, is below the level subject to a Medicare surcharge, the client may still have to make that extra payment since Medicare looks back two years at income levels.

Mastrogiovanni recommends that pre-retirees – along with their financial advisors – review their retirement savings plan to see how much of the income replacement ratio is allocated to health care costs and how much more they need to save, assuming that health care inflation will run at 6% annually before and after retirement and that the client will be paying the 100% of health insurance costs.

He also recommends that portfolios include a mix of products since some accounts, such as Roth IRAs, variable life insurance, nonqualified annuities and Health Savings Accounts are not considered income for purposes of means testing income subject to Medicare surcharges.

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