Many financial advisers rely on income replacement ratios to estimate the annual income needed to maintain a desired lifestyle in retirement. Although a general inflation assumption of between 2.5% and 3% may be appropriate for most future expenses, it could fall far short of actual health care expenses and derail the overall retirement income plan in the process.
The most widely used range of income-replacement ratio in financial planning is 75% to 85% of pre-retirement income. This rule of thumb is useful to both financial advisers and retirement plan participants to assess future retirement-income needs without having to calculate individual line-item expenses. The problem is health care expenses are expected to rise at double the rate of core inflation for the foreseeable future. The Centers for Medicare & Medicaid Services Office of the Actuary project health care spending to rise by about 6% per year through 2024.
Because many past and current retirees still enjoy company-sponsored health plans, pensions and relatively low monthly outlays for Medicare, paying for health care has rarely been considered a major threat to retirement budgets.
But it will be a different story for future retirees. With health care inflation driving costs higher, increased longevity projected for many Americans, and Medicare means-testing imposed on higher-income retirees, health care costs will consume a much more substantial portion of future retirees' budgets.
A soon-to-be-released white paper by HealthView Services, a leading provider of retirement health care cost data and planning tools, reveals a significant gap between health care costs covered by standard income-replacement rates and the projected costs that retirees will likely have to pay. But HealthView says that the gap can be closed through modest additional savings during the final decade prior to retirement or by the use of a higher replacement rate.
MEDICARE NOT ALL INCLUSIVE
Many Americans mistakenly believe that Medicare will cover most or all of their health care costs in retirement. In reality, the government health care program for Americans 65 and older covers only about half of health care expenses.
Medicare A, which is free for most retirees, covers hospitalization. Medicare B, which covers outpatient services and doctor visits, requires a monthly premium that is usually deducted directly from Social Security benefits. Medicare D, which pays for prescription drugs, also requires a monthly premium.
Most retirees also purchase supplemental Medigap coverage to pay for the various deductibles and co-pays associated with Medicare A and B services. Dental expenses, hearing aids and vision exams, including eyeglasses, are not covered by Medicare or Medigap insurance.
Medicare premium surcharges apply to retirees whose Modified Adjusted Gross Income (MAGI), which includes tax-free interest, exceeds $85,000 for individuals or $170,000 for married couples, according to Medicare.gov. Crossing the first threshold can increase Medicare B and D costs by about 35% and surpassing the highest threshold can inflate premium costs by more than 200%.
In 2015, most Medicare beneficiaries pay $104.90 per month for Medicare B and an average of $44 per month for Medicare D, which varies by plan. Income-based surcharges can add from $42 to $230.80 per month on top of the standard $104.90 Medicare B premium and an additional $12.30 to $70.80 per month on top of the standard Part D premium. The charges are per person, so married couples where both spouses are eligible for Medicare pay twice as much. HealthView estimates that 35% of adviser clients are subject to Medicare surcharges.
Although these initial thresholds that trigger Medicare premium surcharges may seem high, more and more retirees will be subject to surcharges as salaries continue to rise, and income-replacement rates keep pace with those increases. Beginning in 2018, some of the income tiers will be adjusted downward, meaning even more retirees will pay higher Medicare premium surcharges.
Last year, HealthView partnered with the Insured Retirement Institute to provide IRI-member companies access to HealthView Prime, a retirement health care cost-planning tool to help integrate these costs into retirement plans.
Drawing upon cost data from more than 50 million annual health care cases, the tool estimates average longevity and expected retirement health care costs based on age, gender, health, state of residence and time in retirement. Charges are based on adviser usage. Individuals can use a free one-click version of HealthWealthLink to calculate average retirement health care costs.
By modifying the mix of investment products in a portfolio, an adviser may be able to move a client into a lower MAGI bracket, decreasing the Medicare premium surcharges, as well as overall income taxes. The end result is higher net disposable income in retirement.
Some sources of income are not included in the MAGI calculation and therefore can reduce both Medicare B and D surcharges, as well as overall income taxes. They include distributions or loans from cash-value life insurance, non-qualified annuities, Roth IRAs or Roth 401(k)s, health savings accounts, longevity insurance and proceeds from a reverse mortgage.
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