A New Way to Calculate Retirement Health Care Costs

• We believe viewing retirement health care costs as an annual expense, instead of as a lump sum, makes it easier for retirees to plan for and pay for them.
• Health insurance premiums  are usually fixed and can be budgeted for and funded from monthly income. On the other hand, out-of-pocket expenses can vary from month to month and could be paid from savings or a fund earmarked for those purposes.
• Retirement health care costs can vary widely, depending on the type of insurance a retiree chooses, and no type of coverage is “typical.” So we believe it is useful to provide these estimates based on the type of insurance coverage.

As mentioned earlier, cumulative health care cost estimates are useful in conveying the overall risk of health care costs in retirement, but there are certain disadvantages of using these estimates.

• It's hard to build a financial plan around a lump sum since health care expenses are not incurred as a lump sum, and it is not clear how such information can be used to plan for retirement health care costs. Let’s take an example of a hypothetical 65‑yearold couple who needs $300,000 to fund their health care costs in retirement. How should they go about it? Should they set aside $300,000 from their retirement savings at age 65 to meet their future health care cost needs? If so, how should they allocate the sum between savings and investments? And what if they only have $280,000 in retirement savings? Does that mean they have no chance of affording their projected health care expenses? And if they should not set aside the $300,000 as a lump sum, how much do they need at age 65, 75, or 85? These types of questions immediately point out the problems one might face when using these lump-sum estimates to plan for health care costs in retirement.
• The burden of health care costs seems higher when the cumulative approach is applied to health care costs alone without including income and assets. If we're going to treat health care as a lump sum, let’s apply that framework to the entire financial situation of a household and include assets and income.
  
  Again, let’s take the example of our hypothetical 65-year-old couple. Assume that they have $400,000 in retirement savings and their combined monthly Social Security benefit is $2,000. Surely, the $300,000 needed for health care costs seems daunting for this couple. But instead of saying they receive $2,000 per month from Social Security, let’s say that with a 2% annual cost-of-living adjustment (COLA), the couple will receive approximately $583,000 in Social Security benefits in the next 20 years.⁶ So, now, with almost $1 million in assets between retirement savings and lifetime Social Security benefit payments, the $300,000 projected for health care expenses seems less alarming.
  
  Keep in mind that assets usually appreciate over time. So, let’s assume the $400,000 in retirement savings produces a 4% nominal return every year and the couple uses the returns to pay for health care and other expenses while keeping the principal intact. Now, they have another $320,000 (not adjusting for inflation) worth of income generated from their retirement savings over 20 years in retirement. Between retirement savings ($400,000), income generated from retirement savings ($320,000), and lifetime Social Security payments ($583,000), our couple has approximately $1.3 million. This makes the $300,000 health care costs estimate less intimidating. So, when all the numbers are presented as lump sums, the perception of risk changes.

This example clearly shows that the perception of risk changes based on how these costs are framed. 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.

Although most Americans aged 65 or above are covered by Medicare, the type of coverage is not uniform. There are several components of Medicare, and retirees have various options for how they want to receive their Medicare benefits. Each option comes with different cost implications.

Medicare consists of four parts:

• Part A: Covers room and board in the hospital. Part A has no premium for most people who have worked for at least 10 years in the U.S. and paid FICA taxes, but there are copayments and deductibles. However, a lot of the actual care received in a hospital falls under Medicare Part B.
• Part B: Covers outpatient services (e.g., doctor visits, lab tests, imaging services, surgeries, etc.) that are deemed medically necessary. Part B has a monthly premium, which can be deducted from Social Security payments. Part B also has copayments and deductibles.
• Part C (Medicare Advantage): This  is the most confusing part of Medicare as it does not cover any specific medical benefits like Parts A, B, or D, which all have associated deductibles and copayments and sometimes no cap on out-of-pocket expenses. All these can result in significant out-of-pocket expenses. Part C essentially offers a way of reducing those expenses through private health insurance plans. Under Medicare Advantage (MA), individuals receive benefits of Parts A, B, and D and often additional services from a single private insurer. Usually, individuals have to pay a monthly premium in addition to Part B premiums and are subject to the network restrictions  and other plan rules. MA plans can be either HMO or PPO plans. It is important to note that once enrolled in Part C, care is delivered through the private insurers instead of Medicare.
• Part D: This federally created program is aimed at lowering costs of prescription drugs. Under Part D, people have to sign up for drug plans offered by private insurance carriers. Part D is optional, but paying a monthly premium usually results in lower copayments for medicines than not having any drug plan.
• Supplemental Insurance: Another way of lowering the out-of-pocket costs of traditional Medicare is to use a supplemental plan. The most common type of supplemental insurance is Medigap. These plans charge monthly premiums and protect from the out-of-pocket costs associated with traditional Medicare. Medigap policies are offered by private insurers. They are highly standardized under Medicare guidelines and are accepted in any facility that accepts Medicare. Other forms of supplemental insurance could include employer-sponsored insurance or Medicaid.

The advantages of separating out premiums from out-of-pocket expenses include:

• A better understanding about the risk of health care expenses: The risk or uncertainty of health care costs is primarily associated with out-of-pocket expenses because they vary more widely than fixed premiums. For example, according to our estimates for those 65 and above with traditional Medicare (Part A and B) and a prescription drug plan (Part D), the 25th percentile and 90th percentile for annual premiums are $2,500 and $3,300, respectively. In comparison, the 25th and 90th percentiles for out-of-pocket expenses for the same group are $300 and $5,000. Also, year-to-year variation in insurance premiums for individuals is often predictable. From Figure 1, we can see that health insurance premiums constitute between 77% and 83% of retirees’ health care expenses regardless of the type of coverage. This means that for a majority of retirees, a large part of their health care expenses is predictable and does not change much on a year-to-year basis. This helps make planning for such expenses easier.

We use the announced 2022 Medicare premiums and data from the Health and Retirement Study (HRS) to calculate the health care cost estimates for the 65 and older population. The HRS data are used to calculate the out-of-pocket expenses for each type of health insurance coverage and the income surcharges for premiums. We examined three different sets of health care cost estimates corresponding to three different health insurance coverage types:

• Traditional Medicare (Parts A and B) and a prescription drug plan (Part D)
• Medicare Advantage HMO plan with prescription drug coverage (MA‑PD plan)
• Traditional Medicare (Parts A and B), a prescription drug plan (Part D), and Medigap

We present estimates separately for premiums, out-of-pocket expenses, and total health care costs as well. We also present a detailed description of the distribution of these costs by presenting the 25th percentile, 50th percentile (median), 75th percentile, and the 90th percentile. We do not present the mean or average costs because averages are not a good summary measure for highly skewed distributions (like the distribution of out-of-pocket expenses and total expenses).

Figure 2 shows the estimated health care costs of retirees with coverage through traditional Medicare (Part A and Part B) and prescription drug coverage (Part D). Median total annual expenses for this type of coverage is $3,800, with the bulk of it paid as premiums. So, half of retirees with this type of coverage will spend less than $3,800 and the other half will spend more. As discussed earlier, out-of-pocket expenses have a much wider variation (25th percentile is $300 and 90th percentile is $5,000) than premiums (25th percentile is $2,500 and 90th percentile is $3,300). This underscores the importance of separating the two as discussed in detail earlier.

According to the Kaiser Family Foundation (KFF), enrollment in Medicare Advantage plans has doubled in the past decade (from 9.7 million in 2008 to 20.4 million in 2018).¹⁰ Among Medicare Advantage plans, MA-PD plans are by far the most popular because of lower premiums. According to the same KFF study, in 2018, 51% of MA-PD plans had no premium (in addition to Part B premiums) and the average monthly premium was only $34. While HMOs offer lower premiums, they also come with network restrictions and often require prior authorization for services.

Figure 3 shows the costs associated with Medicare Advantage HMO plans with prescription drug coverage (MA-PD plans). A quick comparison of MA-PD HMO plan premiums with traditional Medicare with prescription drug coverage discussed in Figure 2 shows that the premiums for MA‑PD plans are significantly lower. This might explain the rising popularity of MA-PD HMO plans. Out-of-pocket expenses are similar for the bottom halves (50th percentile and below) of these two types of plans, but higher in the top half (above 50th percentile) for traditional Medicare plans with prescription drug coverage. In general, comparing Figures 2 and 3, we can say that the costs are lower for MA‑PD HMO plans compared with traditional Medicare with Part D coverage.

Finally, Figure 4 illustrates the health care costs for retirees with traditional Medicare (Parts A and B), a prescription drug plan, and supplemental health insurance through Medigap. Supplemental insurance can take various forms. The Kaiser Family Foundation estimates that out of all traditional Medicare beneficiaries in 2016, 30% had supplemental employersponsored insurance, 29% had Medigap insurance, and 22% had coverage through Medicaid. For our discussion, we focus on Medigap because those with employer-sponsored insurance are unlikely to look for other types of coverage, and those under Medicaid might not have any other option. We don’t consider any particular type of Medigap policy (like Plan F or Plan N). Premiums in Figure 4 represent the distribution of premiums of all Medigap policies that can be purchased directly from an insurance company, insurance exchange, or group plans provided by AARP.

It is clear that depending on what type of health insurance coverage an individual selects, health care expenses could be very different in both total health care expenses and the mix of premiums and out-of-pocket expenses. So this framework could be very useful to help individuals plan for their health care expenses based on the type of coverage they have.

Since, health insurance premiums are known in advance and can be easily included in the budget or income plan, retirees might be better served by planning to pay them from their monthly income, which might include Social Security benefits, pension payments, other annuity payments, systematic withdrawals from retirement accounts, etc. and use a dedicated pool of assets like a savings account earmarked for out-of-pocket expenses.

How much savings should someone have available at any point in time to meet the out-of-pocket costs? A safe strategy could be to hold the amount indicated by the 90th percentiles. For example, if someone with an MA-PD plan keeps $4,000 for annual out-of-pocket expenses, chances are that in 9 out of 10 situations, she will be able to cover those expenses. Depending on the individual’s health care needs and risk tolerance, the savings amount can be increased or decreased.

More importantly, the advantage of this approach is that one does not have to hold enormously large sums in savings accounts in advance of retirement, and as a result, 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.

The most tax-advantaged way to save for retirement health care costs is through a Health Savings Account (HSA).¹² HSAs are triple tax-advantaged, i.e., income is not taxed when contributed to an HSA, investments grow tax-deferred, and withdrawals are tax-free if the funds are used for qualified medical expenses. You can pay Medicare premiums (but not Medigap premiums) and qualified out-of-pocket expenses with tax-free withdrawals from your HSA. If you are currently saving for retirement and have access to an HSA, you might consider using it for long-term investment purposes. If you are already retired and have some money in an HSA, consider keeping a portion of your HSA in cash to pay for near-term qualified health care expenses.