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Why Your Retirement Spending Estimate Is Wrong

The 'X Factor' that could derail your plans

By Richard Eisenberg

When planning for retirement, people tend to focus on whether they will have saved enough. But it’s equally important to pencil out how much you expect to spend.

And that brings me to some disheartening news: After reading several recent studies plus Medicare forecasts, I’m convinced there's a good chance you'll need to count on spending more out-of-pocket for health care in retirement than you expect. Which means — sorry — there's a good chance you need to save even more now.

Financial advisers often say that retirees should have enough income in retirement to replace about 80 percent of their pre-retirement income; that 80 percent is known as the Income Replacement Ratio or IRR. The money pros use that percentage because some costs tend to drop or disappear in retirement (things like work-related expenses).

Underestimating Health Costs in Retirement

But a new study from HealthView Services, which provides retirement health cost data and planning tools, says this guideline severely underestimates retiree health care costs — which amount to roughly 13 percent of annual spending for people 65 and older.

And, says HealthView Services Founder and CEO Ron Mastrogiovanni, if you base your retirement savings around the 80 percent rule, the health-cost reality could mean you’ll fall far short of your goals.

Income Replacement Ratios, says Mastrogiovanni, normally assume that household expenses in retirement will rise with overall inflation — by about 2.5 percent to 3 percent a year. But HealthView Services forecasts health care costs (including Medicare Part B premiums) to rise about 6 percent annually for the next 10 years. Medicare Part D premiums for prescription drugs, which have been growing by about 12 percent a year, will climb an average of 8 percent a year over the next decade, says HealthView Services.

Another factor the replacement-income rule of thumb ignores: increasing longevity.

The HealthView Services report says a 55-year-old male with an average life expectancy of 86 who lives to 88 “will be responsible for an additional $69,627 in health care costs that are not included” in typical replacement ratio calculations.

It gets worse: If your Modified Adjusted Gross Income in retirement exceeds $85,000 ($170,00 for couples), that could more than double your Medicare Parts B and D premiums, due to means-tested Medicare surcharges. Mastrogiovanni says those thresholds are not expected to rise with inflation, which means more and retirees will hit them; the surcharges can boost the premiums by 37 percent to 204 percent.

If you think these projections sound overly gloomy, consider this: The government’s own Centers for Medicare & Medicaid Services (CMS) forecasts at least eight years of annual health care inflation between 5 and 7 percent. And CMS projects out-of-pocket Medicare costs for the average Medicare beneficiary to rise steadily in coming decades, from 23 percent of Social Security benefits in 2014 to nearly 40 percent by 2080.

Medicare Part B premiums won’t rise next year for most beneficiaries, because they’re tied to Social Security Cost of Living Adjustments and low inflation means there won’t be any adjustments. But due to a quirk in how Medicare premiums are set, high-income Medicare beneficiaries and first-time Medicare enrollees will pay Part B premiums in 2016 that are 15 percent higher than in 2015 — $120.70 plus a $3 monthly surcharge.

Health Care Savings Targets Are Up

Another study, from the Employee Benefit Research Institute (EBRI), finds that projected savings targets needed to cover health care in retirement have been rising, after falling during 2012 to 2014.

EBRI says the projected health care expense in retirement for a married couple with median prescription drug costs soared 7.5 percent from 2014, to $158,000. If that couple wanted to be 90 percent sure they’d have enough saved for health care, EBRI says they’d need a savings stash of $259,000 just for medical expenses. If they had high prescription drug costs and wanted to be 90 percent confident they’d have enough in health-cost savings by age 65, their target amount would be — gulp — $392,000.

EBRI’s “health savings target” figures rose 6 to 21 percent between 2014 and 2015. And they don’t even include savings that might be needed for long-term care expenses, means-tested Medicare premiums or health costs incurred by people retiring before Medicare kicks in at age 65.

“The main reason for the increase in needed savings is related to the yearly adjustment for out-of-pocket spending for prescription drug use,” said Paul Fronstin, director of EBRI’s Health Research and Education Program, in a news release issued with his report.

Retiree Health Benefits Are Vanishing


One more piece of depressing news that these two studies didn’t mention: Fewer and fewer employers are offering health benefits to their retired employees.

In 1988, according to the Kaiser/HRET Survey of Employer-Sponsored Health Benefits, 66 percent of firms with 200 or more workers provided retiree health benefits; in 2013, only 28 percent did. And just 5 percent of firms with three to 199 workers offered retiree health benefits in 2013.

This downward spiral is only likely to continue. “The prevalence of retiree health coverage is expected to decline incrementally over time,” said the 2014 Kaiser Family Foundation report, Retiree Health Benefits at the Crossroads.

Little wonder why 72 percent of employees within five years of their planned retirement are concerned about losing health benefits when they retire, according to the recent Guardian Workplace Benefits Study from Guardian Life Insurance.

Estimate Your Retirement Spending

All of this is to say that if you’re within five years or so of retirement, it would be a good idea to realistically estimate how much you’ll spend, and thus, how much income you’ll need. This calculation can vary enormously, depending on your retirement goals and your health.

You could find that the amount of retirement income that’ll satisfy you is much less than what you live on now. Actuary Frederick Vettese, the contrarian author of The Essential Retirement Guide, maintains that many people need just 50 percent of their pre-retirement income to continue living the way they did before retiring.

Michael Finke, a Texas Tech University professor, also believes you may not need to replace 80 percent of your pre-retirement income. He told MarketWatch’s Robert Powell that your income needs may be lower because, for example, you’ll no longer contribute to Social Security or to Medicare or to your retirement account.

That said, EBRI’s data says nearly half of retirees increase their spending at the start of retirement. They want to increase travel and dine out more, for instance.

At the Financial Planning Association conference I attended in September, David Blanchett, head of retirement research at Morningstar Investment Management, said that retirement spending tends to resemble a smile: “It declines until you’re 70, then stays flat until you’re 80 and then rises.”

Added Blanchett, who has won an award for his retirement-spending research: “Health care is the big X factor.”

Photograph of Richard Eisenberg
Richard Eisenberg is the former Senior Web Editor of the Money & Security and Work & Purpose channels of Next Avenue and former Managing Editor for the site. He is the author of "How to Avoid a Mid-Life Financial Crisis" and has been a personal finance editor at Money, Yahoo, Good Housekeeping, and CBS MoneyWatch. Read More
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