Health costs derail common retirement savings benchmark

Steeply rising health costs call for a more dynamic retirement planning approach than traditional income replacement ratios

Nov 12, 2015 @ 1:20 pm

By Greg Iacurci

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Ballooning health care costs mean that more retirement nest eggs may be at risk, and a common retirement-savings metric may be luring Americans into a false sense of security.

So-called "Income-Replacement Ratios," or IRRs, are a broadly used benchmark for determining if individuals' assets will be able to last throughout their retirement years.

The rule of thumb typically says that amassing about 75% to 85% of an individual's pre-retirement income per year will allow for an equivalent lifestyle in retirement as during one's working years.

However, using that pre-retirement-income figure as a sound barometer to gauge income needs in retirement doesn't work when it comes to health care, according to a new study by HealthView Services Inc., a provider of health care planning tools for advisers.

“Health care is the biggest question mark,” said Scot Hanson, financial adviser at EFS Advisors. “It's usually going to be whatever [clients] estimated was too low.”

The report, “Retirement Health Care Costs and Income Replacement Ratios,” contends IRRs provide advisers with a streamlined way of gauging clients' retirement readiness, but fails to appropriately tailor a financial plan to clients in a detailed, comprehensive way through the inclusion of “individual line-item expenses” such as health costs.

For one, IRRs pre-retirement health expenses can't be used to predict those expenses in retirement, because expenditures are very different, the report argues. For example, working Americans pay approximately 25% of their health costs — or, group insurance premiums — with employers paying the remainder. However, retirees are responsible for almost 100% of their health care costs.

Further, the pace of inflation in the U.S. health care sector far outstrips that of the inflation assumption used in typical income-replacement models. HealthView projects health care inflation, including Medicare Part B, to grow an average 6% annually for the next decade, while IRRs traditionally assume household expenses with a rate of around 2.5% or 3%.

David Edwards, president of Heron Financial Group, said he starts with a 100% income-replacement goal with clients, rather than 80%. The approach he uses is a dynamic one, and the 100% replacement target could change as new information or situations arise that affect a client's financial plan.

Eighty percent could ultimately be the magic number, depending on the client, he added.

“All of these prescriptions about what is a good target income rate, sustainable withdrawal rate, are nice rules of thumb to start with, and then you have to actually get into the weeds and figure it out,” Mr. Edwards said. “The financial planning process isn't a map set in stone. It's like a GPS. 'Based on what you told us, this is the route to your destination.'" And if something changes, then route changes accordingly.

Medical expenses are the third-highest expenditure for those 65 years and older, making up an average 13.4% of annual expenses. For those who are 45 to 54 years old, on the other hand, medical expenses are the fifth-largest expenditure, taking up 6.8% of annual outlays.

Mr. Edwards aims for a 100% income replacement initially with clients because while the medical portion of expenses is higher, many other expenses are lower — mortgages are usually paid off, the tax bill is generally lower, and clients aren't spending as much money on items such as clothing and furniture, for example. The “mix” of expenditures changes, but the overall level of income needed remains fairly level in retirement.

Too often, people underestimate how much they'll need in retirement, according to John McManus, founder of McManus & Associates.

“We're not seeing advisers thinking through enough [on medical cost] and adding that to the cost of retirement,” Mr. McManus said.

“You're not wrong by being liberal in your [retirement] calculations,” he added. “You should be liberal because the worst thing that happens if you've been too liberal is you have more money, and you're not feeling like your tank is on empty.”

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