Modern Retirement Framework Must Consider Health Care Costs

Vanguard has published a report recounting recent analytical work conducted in collaboration with Mercer Health and Benefits, aimed at helping employers better understand their role in supporting the health care needs of late-career workers and retirees.

According to the report, “Planning for health care costs in retirement,” planning for annual health care insurance premiums and out-of-pocket expenses at retirement “should be distinct from planning for long-term care expenses.”

“Some research on health care costs in retirement estimates these expenses as a lifetime lump sum,” the report points out. “We believe that a better planning framework considers these costs as annual expenses personalized to an individual’s health status, coverage choices, retirement age, and loss of any employer subsidies.”

According to the analysis, for a typical 65-year-old woman, the Mercer-Vanguard model predicts an annual health care expense of $5,200 in 2018. To meet this sizable expense, during their working years, the model suggests many individuals should save at higher rates to account for potential future incremental health care spending.

“Workers with generous employer health care benefits that may not be offered in retirement and those at higher risk of chronic conditions because of their family history or current health status should target higher replacement ratios,” the analysis posits. “Long-term care costs represent a separate planning challenge given the wide distribution of potential outcomes. Half of individuals will incur no long-term care costs—but there is a small but meaningful risk that costly care will be required for multiple years.”

According to the research report, for a typical 65-year-old woman, the Mercer-Vanguard model predicts an annual health care expense of $5,200 “based on purchasing a Medicare Supplemental Plan F and a standard prescription drug plan.”

“Understanding how an individual’s annual health care costs will change at retirement requires understanding the impact of key personal attributes, including health status, coverage choices, geography, income, and loss of employer subsidies,” the report states. “Routine health care costs include insurance premiums and out of pocket costs, but not expenses associated with paid long-term care.”

Vanguard and Mercer warn that employees with generous health benefits, but which do not continue to receive those benefits in retirement, may need to target higher income replacement ratios when it comes to their preparedness to meet health care costs in retirement. Important to note, health care costs are likely to increase during retirement because of both increased health care consumption and faster-than-inflation growth in the cost of health care services.

“Planning frameworks need to balance this growth against substitution effects that occur when retirees spend less in other consumption categories as they age,” the report suggests. “The expression of annual health care costs as a lump sum is not a useful framework for discussing retiree health care expenses. Instead, individuals should focus on annual costs, especially the incremental annual changes they will experience at retirement and at Medicare enrollment.”

The report concludes that “framing annual health care costs as an incremental change, at retirement and at Medicare eligibility, is a more practical approach than focusing on daunting lump sum estimates.”

“Financial plans should factor in the personal characteristics of each retirement investor,” the report states. “Factors that can significantly affect costs include health status and risk, Medicare coverage choice, retirement age, employer subsidies, geography and Medicare surcharges.”