Estimates showing astronomical health care costs in retirement can be quite intimidating, giving the impression health care will be unaffordable in retirement. But a recent report argues there’s a simpler, more logical way to plan for these costs.
Given that health care costs are incurred over time, T. Rowe Price’s “A New Way to Calculate Retirement Health Care Costs” contends that it makes more sense to approach these costs as an annual expense and ongoing regular budget item instead of a lump sum needed at the start of retirement.
“Any type of expense incurred over a 20- to 30-year period can look daunting when summed up,” writes Sudipto Banerjee, Ph.D., Senior Manager of Thought Leadership at T. Rowe Price and author of the paper. “We might balk at the thought of prepaying an $86,000 cable bill in retirement, but that’s not how we pay for cable. Similarly, estimating cumulative future health care costs is not useful because we don’t prepay for health care.”
Banerjee suggests, instead, that individuals planning for retirement should think about premiums and out-of-pocket expenses differently. “Given that month-to-month premiums are fixed and premiums make up the bulk of annual health care expenses means that most of annual health care expenses are predictable. So they can be budgeted for and paid from monthly income,” he explains.
Conversely, with out-of-pocket expenses varying greatly from individual to individual and from month to month, Banerjee suggests that maintaining a savings account fund with enough liquid savings to meet the annual out-of-pocket expenses and replenishing it annually might be a good way to address the uncertainty of out-of-pocket expenses.
Breaking Down the Costs
The paper points to EBRI data showing that a 65-year-old couple may need up to $400,000 to cover health care costs in retirement, but reminds readers that most of the “astronomical numbers” often correspond to a few unfortunate people who experience very high expenses over a prolonged period.
According to T. Rowe Price’s estimates, half of retirees with traditional Medicare (Parts A and B), a prescription drug plan (Part D) and Medigap will spend less than $1,100 a year on out-of-pocket expenses, and only 1 in 10 will likely spend more than $4,500 a year on these expenses. The paper further observes that someone spending $4,500 in out-of-pocket expenses will not necessarily keep doing so for the rest of his or her life.
“Your actual health care expenses will be a combination of regular, predictable expenses that you can budget for and, for most people, a smaller component of variable expenses that you can manage from your savings,” says Banerjee.
Moreover, he notes that the burden of health care costs seems higher when the cumulative approach is applied to health care costs alone without including income and assets. The paper explains, for example, that if health care costs are treated as a lump sum, then applying that framework to the entire financial situation of a household – including retirement savings, income generated from retirement savings and lifetime Social Security payments – makes the lump sum health care cost estimate seem much less intimidating.
“This example clearly shows that the perception of risk changes based on how these costs are framed,” says Banerjee. “Instead of converting everything into a cumulative lump-sum amount covering decades, it is better – and more prescriptive – to provide annual or point-in-time estimates because that is how most people assess these numbers,” he emphasizes.
Don’t Panic
So what guidance can advisors offer? Banerjee suggests that the first step is to “replace panic with prudent planning” by presenting health care expenses rationally, as a combination of predictable monthly expenses that can be budgeted for and less predictable expenses that can be managed from savings.
Advisors should next emphasize careful consideration of Medicare options, comparing premiums, coverage and out-of-pocket expenses. And finally, he recommends keeping a liquid cash reserve to help cover unpredictable expenses, replenishing it each year based on the previous year’s expenditures.
Banerjee further observes that the advantage of this approach is that one does not have to hold enormously large sums in savings accounts in advance of retirement and forgo investment or interest earnings. “After allocating for the annual out-of-pocket health care expense needs, retirees can keep the rest of their assets invested and benefit from potential returns to meet their other needs, including long-term care,” he says.
