Personal Finance

A New Way to Calculate Retirement Health Care Costs

March 12, 2019
Separating premiums and out-of-pocket costs makes it easier to plan for expenses.

Key Points

  • 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.

Health care costs are top of mind for every retiree or anyone who is nearing retirement. According to T. Rowe Price’s Retirement Savings and Spending study (2018), the top three spending concerns of retirees are (in order of importance): paying for long-term care services, health insurance premiums, and out-of-pocket health care expenses.1

The projected health care costs in retirement provided by some of the leading experts sound alarming. In its latest (2018) projection, the Employee Benefit Research Institute (EBRI) estimates that to have a 90% chance of covering all their health insurance premiums and out-of-pocket costs, a 65-year-old couple will need $296,000.2 And according to the most recent (2010) estimates from the Boston College Center for Retirement Research (CRR), a typical 65-year-old couple can expect to spend $197,000 over their remaining lifetime with a 5% chance that the number exceeds $311,000.3

Premiums, similar to other monthly expenses, like a cable or utility bill, are often paid from monthly income. On the other hand, out-of-pocket expenses are much more likely to be funded from savings.

- Sudipto Banerjee, Ph.D., Senior Manager, Thought Leadership

These numbers don’t include long-term care costs, which could be catastrophic in some cases.

While these numbers offer a good idea of how expensive retirement health care could be over several decades, they are not very helpful for individual financial planning. Here’s why:

  1. Lump-sum estimates of health care costs covering the entire duration of retirement are not useful for budgeting and planning purposes because health care expenses are not incurred as lump sums. Individuals have to make their health care decisions based on their financial resources at any given point in time.
  2. There are embedded health insurance coverage assumptions in most of these calculations. Health insurance coverage varies significantly for retired Americans, even under the broad umbrella of Medicare. It is not clear if any particular type of health insurance coverage can be termed as “typical."
  3. Combining premiums and out-of-pocket costs tends to distort the perception of the risk of health care costs in retirement and complicates the associated financial planning. Premiums are relatively stable at the individual level, but out-of-pocket costs are more uncertain and, as a result, account for most of the variation in health care costs. Premiums also constitute the bulk of health care expenses for the majority of retirees. As a result, for most retirees, a large chunk of their annual health care costs is predictable and can be easily planned for, a fact masked by the combined lifetime health care cost estimates.

By separating the premiums and out-of-pocket costs, retirees will be able to plan better for these expenses. Premiums, similar to other monthly expenses, like a cable or utility bill, are often paid from monthly income. On the other hand, out-of-pocket expenses are much more likely to be funded from savings.

As a result, we believe that framing health care costs in retirement should be based on (at least) three factors:

  • Annual costs
  • Type of health insurance coverage
  • Separation of premiums and out-of-pocket expenses

From an individual perspective, the more personalized the estimates are, the better. To that effect, a host of other factors (like income, age, health status, marital status, state of residence, etc.) can be added to this framework. But since it is not always possible to reliably estimate retiree health care costs using all these factors, we think our three-factor approach is a reasonable basic framework to estimate health care costs in retirement. Also, presenting a detailed picture of the distribution of these costs—rather than single-summary measures like averages—addresses some of the personalization needs. For example, someone in excellent health might expect to be in the bottom quartile of out-of-pocket expenses, while someone with one or more serious chronic conditions might find themselves in the top decile of out-of-pocket expenses.

For the purposes of this research, we chose not to include the cost of long-term care. Although a majority of individuals do not incur out-of-pocket long-term care expenses during their retirement years, it could be catastrophic for a small fraction of retirees.4 The uncertainty of incurring any out-of-pocket long-term care expenses combined with the highly skewed distribution of long-term care expenses makes it very difficult to plan for them. But there are a couple of ways people can prepare for long-term care expenses. Buying long-term care insurance could be a solution. There are a number of factors that could influence the decision to purchase long-term care insurance, including premiums (which could be very high), the level of assets an individual wants to protect, bankruptcy concerns about insurers, and the lack of caregivers. The other way is to self-insure using personal savings and then depend on Medicaid if assets are exhausted.

Below, we discuss in more detail why it is important to use annual costs, type of health insurance coverage, and separation of premiums and out-of-pocket expenses for a basic framing of retiree health care costs. Then, using this framework, we present health care cost estimates based on data from the Health and Retirement Study (HRS)5 and projected 2019 Medicare premiums. We also provide some guidelines on how individuals can plan to meet these expenses.

1The Retirement Savings and Spending (RSS) study is a nationally representative annual survey of workers ages 21 and above who are either currently participating in a 401(k) plan or eligible to participate and have a plan balance of at least $1,000. Along with 3,000 workers, the 2018 RSS study also includes a sample of 1,000 retirees who had a rollover IRA or a left-in-plan 401(k) balance.
2Fronstin, Paul and Jack VanDerhei. “Savings Medicare Beneficiaries Need for Health Expenses: Some Couples Could Need as Much as $400,000, Up From $370,000 in 2017.” EBRI Issue Brief, no. 460 (Employee Benefit Research Institute, October 8, 2018).
3Webb, Anthony and Natalia Zhivan, March 2010. “What Is the Distribution of Lifetime Health Care Costs from Age 65?” Center for Retirement Research at Boston College, No 10-4.
4Banerjee, Sudipto. “Cumulative Out-of-Pocket Health Care Expenses After the Age of 70,” EBRI Issue Brief, no. 446 (Employee Benefit Research Institute, April 3, 2018).
5Health and Retirement Study, public use dataset. Produced and distributed by the University of Michigan with funding from the National Institute on
Aging (grant number NIA U01AG009740). Ann Arbor, MI.

This material has been prepared by T. Rowe Price for general and educational purposes only. This material does not provide fiduciary recommendations concerning investments, nor is it intended to serve as the primary basis for investment decision-making. T. Rowe Price, its affiliates, and its associates do not provide legal or tax advice. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this material.

The views contained herein are those of the authors as of February 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

All investments involve risk. All charts and tables are shown for illustrative purposes only.

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