Demystifying health care costs in retirement

A recently published working paper by five economists—three of whom are staffed at Federal Reserve banks—is the latest in a growing line of academic work projecting out-of-pocket health care costs in retirement.

Using data from the Health and Retirement Survey and Medicare Current Beneficiary Survey, the research shows that once households reach age 70, they will spend an average of $122,000 in out-of-pocket medical costs over their lifetime; 5 percent of households will need more than $300,000 to cover out-of-pocket costs; and 1 percent will incur more than $600,000 in costs.

In April, Fidelity Investments reported a 65-year old couple retiring this year will need $280,000 to cover out-of-pocket medical expenses over the remainder of their lifetimes, according to the firm’s annual retiree health care cost estimate research.

Public and private sector cost models tend to acknowledge the difficulty in projecting future out-of-pocket costs, due to variances in drug costs, Medicare premium rates, and unknown variables in a given retiree’s health status.

The paper released by the Federal Reserve economists in April represented a considerable revision from a 2010 paper, which put lifetime cost for the average 70-year old couple at $300,000. Slowed inflation in health care spending was one reason cited for the lower projection.

Smart people, big numbers

If there is consistency in the modeling, it’s that smart economists are generating big numbers.

The size of lump-sum projections, and their variability, “can really scare people,” said Derek Guyton, a partner at Mercer.

“But if you have enough information, a big part of annual retiree health care costs are reasonably budget-able at the beginning of each year,” added Guyton.

A year-and-a-half ago, Vanguard set out to throw its hat in the retiree health-care projection ring.

“Increasingly, our clients were asking us about health care in retirement,” said Jean Young, senior research analyst with Vanguard’s Center for Retirement Research. “If we are going to help people plan for retirement, we needed a viewpoint on this.”

After issuing requests for proposals, Vanguard partnered with Mercer to develop what Young and Guyton called an “actionable” modeling tool. “It wasn’t feasible for us to become health care experts in our time frame, so we thought we would be best served partnering with a health care expert,” explained Young.

The upshot of the partnership is a new paper — Planning for Health Care Costs in Retirement — that lays the groundwork for an interactive modeling tool that Vanguard hopes to incorporate within its website in the foreseeable future, said Young.

The paper deviates from much of the existing research that quantifies retiree health care costs in a lifetime lump sum, and instead uses a series of inputs, like health care status, employer coverage status, geography, and Medicare coverage options, to create annual cost projections.

“A lot of retiree health care costs are the same,” said Guyton. “The biggest variable tends to be with prescription drugs. But with the right amount of information you can create an annual budget and get away from a big, scary number.”

“Projections become actionable and relatable when presented as an annual budget number,” added Young.

$400,000 for food, clothing, and shelter in retirement

Lump-sum projections of health care costs can be so lofty that they potentially startle retirement savers into stasis.

A primary premise of the paper, which Young said is the first Vanguard has co-authored with an outside partner, is that retirement planning professionals should think in terms of annual spending and budgeting needs for retiree health care, just as they do for areas of retiree spending.

To underscore the inefficiency of lump-sum health care costs, the paper’s authors pulled Bureau of Labor statistics on other areas of spending.

The average retiree spends about $17,000 annually on food, clothing, and shelter, according to the BLS. That cost “seems reasonable,” according to the paper.

But project a lump sum over the course of retirement, and the number translates to $400,000, or more than three times the lower projections for health care costs. In that context, health care spending “seems small,” the paper notes.

To be clear, Vanguard’s modeling is not saying that annual cost projections are insignificant. Like lump-sum models, annual projections can vary wildly.

Consider a 65-year-old woman with medium health risks living in an area of the country at the median cost of living. She will spend between $3,200 and $6,000 in 2018 for premiums and out-of-pocket medical, dental and vision costs, if she were enrolled only in Medicare with Part D coverage.

The same woman with a low-risk health profile will spend 15 percent less, while a woman with a high-risk health profile will spend 90 percent more. Depending on health status, that woman could spend as little as $3,000 in 2018, and as much as $26,000.

While much of retirees’ core health care costs are somewhat predictable year-over year, for the 50 year-old building a pre-retirement savings strategy, those costs in retirement are largely unknown, explained Guyton.

“The model asks you to predict some things—will you have a spouse, what you think your health status is,” he said.

“It is a model,” added Young, suggesting the inherent uncertainty in all economic modeling. “You are either healthy, or you are not. Increasingly, people know if they are healthy or not. Higher costs come into play if you have chronic health conditions, or if you are in a higher income bracket and are subject to full Medicare surcharges.”

Young described the model as being in a “test and learn mode” — Vanguard is piloting a version within its personal advisor services group.

Plan sponsors too stand to benefit from evolutions in retiree cost modeling. For instance, those not offering a retiree medical benefit might consider increasing default rates to 401(k) plans to account for higher out-of-pocket health care costs in retirement, said Young.

BenefitsPRO related reading:

10 trends in retirement savings behavior: 2018

Godfather of financial wellness analyzes workers’ anxieties

Employees want financial wellness programs, just don’t call them that