Vanguard and Mercer Health and Benefits have developed a new framework that pre-retirees, retirees and their advisors can use to forecast health care expenses in retirement.
Unlike many other models, the framework focuses on annual costs, rather than costs over a lifetime, which can be daunting. It also separates long-term care costs from annual health care costs because long-term care costs are less predictable and many retirees will never incur them.
Here are the top tips from the framework discussed in Vanguard’s new report, Planning for Health Care Costs in Retirement.
1. Frame costs in annual terms. The Employee Benefit Research Institute estimates that a typical 65-year-old couple will spend a total $265,000 in health care costs over their lifetime. The Boston College Center for Retirement Research estimated in 2010 a $197,000 outlay for a retiree couple. Neither estimate includes long-term care. These lump sums are overwhelming and potentially very inaccurate.
There are many variables involved in estimating health care costs in retirement and the total number can vary widely, according to the Vanguard report. A 65-year-old has a 50% chance of living another 24 years, and if she does, she could spend about $200,000 on health care. But if she dies by 81, she could spend less than $120,000, and if she lives to 95, she could spend more than $272,000.
“The range is wide and accounts for only 50% of the possible outcomes. This is why retirement planning professionals should focus on annual spending plans,” according to the report. They should also consider, however, that costs will rise as seniors age due to inflation and the consumption of more health care services.
2. Personalize health care costs. Knowing a person’s health history and current health status as well as the costs and coverage for Medicare plans, including Medicare Parts B (doctors and labs) and D (prescription drugs), Supplemental Medigap and/or Medicare Advantage Plans are important to understanding health care costs in retirement.
The Vanguard/Mercer Model considers 12 chronic health conditions, along with smoker status and number of annual doctor visits to establish a retiree’s likely health care costs and divides people into three risk categories: low, medium and high.
It also considers geography, marital status, age at retirement and coverage choices, and models costs for women rather than men since their health care costs tend to be slightly higher over a lifetime — 2%.
The median annual health care cost for a 65-year-old woman is $5,200, according to the Vanguard/Mercer model, but it ranges from $3,000 to $26,000 based on risk, geography, type of coverage and income. (Taxpayers with adjusted gross income above $85,000 for individuals filing separately and couples above $170,000 filing jointly are subject to Medicare surcharges.)
Vanguard recommends also that pre-retirees understand their employer contributions to their health care coverage — it averages $5,300 per year for workers — because they will have to cover that cost in retirement.
In addition, it recommends that retirees understand the benefits and costs of different health care options: Medicare with prescription drug coverage only, Medicare with prescription drug coverage and a supplemental Medigap plan and Medicare Advantage plans, and the choices within each category where they live.
Retirees should also reassess prescription drug plans and Medicare Advantage plans annually. (They may encounter difficulties in changing Medigap plans if their health has worsened without a significant hike in premium and possibly a denial of coverage.)
3. Target higher replacement ratios. Financial plans typically suggest that retirees will spend 70% to 85% of their current annual income in retirement, but those ratios may be too low, according to the Vanguard report. It doesn’t take into account an individual who may have high medical costs.
In addition, it uses a ratio based on a 2008 study from Aon Consulting, which tends to undercount how much employers contribute today to health care coverage of pre-retirees. In the baseline case, it assumes an employee making $60,000 per year will spend $1,086 for health care coverage in retirement and in the worst case, $4,800, but according to the Vanguard report, “it is not hard to envision scenarios in which ‘worst case’ could be double that assumption.”
4. View health care costs in relation to other costs. “Although health care costs increase, spending in virtually all other categories tends to decline with age,” according to the Vanguard report, referring to categories such as transportation and entertainment. That doesn’t mean, however, that advisors and their clients should plan on saving less. Forecasting higher overall spending growth can serve as a hedge against rising health care costs and ‘worst case’ scenarios.
5. Plan for long-term care costs. “Long-term care costs may actually be the biggest concern for most retirement planning scenarios because the consumption of long-term care varies significantly,” according to the Vanguard report. It notes half of retirees won’t incur these costs; one-quarter will spend less than $100,000 on long-term care and 15% will spend more than $250,000.
“Even if the probability of incurring expensive care is relatively low, the number is of a magnitude that is hard to ignore,” according to the Vanguard report. The median annual cost for a private room in a nursing home runs over $92,000, according to a 2017 Genworth Financial report cited by Vanguard.
It suggests that retirees consider potential long-term care options: unpaid care from family and/or friends, types of facilities and services available in their area, and expenses that can be eliminated or reduced so more funds are available for long-term care and Medicaid. Consultation with an elder law attorney can help seniors understand the role that Medicaid can play and the rules involved.
For those retirees and pre-retirees who believe long-term care insurance will take care of these costs, Vanguard has another message: “Long-term care insurance pays for only a small portion of care in the U.S.” Policies are expensive, include benefit caps and are not always fully useful “in the most severe scenarios,” according to Vanguard.
Financial assets, home equity, income annuities and health savings accounts can also help pay for long-term care costs.
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