Calculating how much annual income your clients need during retirement is a task many financial advisors may seek to address by relying on a simple percentage of pre-retirement income. According to a HealthView Services* report, 80% has become a widely accepted benchmark. But the same report, titled “Retirement Health Care Costs and Income Replacement Ratios,”* warns that the rapidly rising cost of health care casts doubt on the reliability of this ratio as an accurate projection tool.
Why doesn’t the 80% income replacement ratio work for health care? It’s because the calculation based on pre-retirement income may cover only a portion of health care costs often faced during retirement.
One factor to consider is health insurance. Many of your clients may receive a subsidy from their employer during their working lives to help cover insurance premiums. This subsidy may typically total 75% of the true cost of the insurance. The article suggests it’s not accurate to project this expense forward into retirement, because after they retire many clients may be responsible for the entire cost of health insurance, along with increasing co-payments and higher deductibles. The HealthView Services report says post-retirement costs can be higher even if clients qualify for Medicare, which is subsidized by the government.
Then there’s the matter of different inflation rates. Health care costs have been rising faster on an annual percentage basis than the general inflation rate. HealthView Services’ 2017 Retirement Health Care Costs Data Report* projects a continuation of this trend. This report predicts retiree health care expenses will rise at an average annual rate of 5.47% for the foreseeable future. That’s almost three times the U.S. inflation rate from 2012-2016.
Clients should be aware that inflation driving increases in Medicare premiums is calculated differently than inflation for Social Security purposes. (Background information on the Social Security COLA is available at http://ssa.gov/news/cola. Increases in Medicare premiums more closely reflect changes in prices for medical care. The Medicare website explains how Medicare premiums are calculated.)
HealthView Services says the difference between the general inflation rate and projected Medicare inflation can, over time, create a substantial shortfall in retirement savings. The shortfall may be even more acute for couples who earn over $170,000 per year in retirement and must, as a result, pay Medicare surcharges. The company, which produces health care cost-projection software, presents two case studies in its report on income replacement ratios that illustrate the potential impact of underfunding health care costs.
The use of income replacement ratios to estimate retirement needs may be suspect for reasons other than health care costs. A report for the Social Security Administration, “Income Replacement Ratios in the Health and Retirement Study,” explores questions such as:
- Which years of income should be included?
- Should preretirement income be in nominal dollars, or be price-indexed or wage-indexed to a particular year?
- Should income be measured before or after taxes?
There is some good news for your clients, however. If a potential retirement health savings gap is discovered soon enough, a modest additional annual retirement contribution can often reduce or eliminate the impact.
The Scottrade® Strategic Resource Center provides a platform allowing you to connect with organizations that specialize in retirement plans as well as technology, compliance, research, education and marketing. Many of these resources offer discounts to advisors who custody assets with Scottrade. (Scottrade provides this resource for informational purposes and does not specifically endorse any of the businesses within the directory. Scottrade also does not pass judgement as to whether those services are appropriate for specific business needs. Be advised this is not a full and comprehensive list of businesses that offer these types of products or services and that advisors are responsible for doing adequate research before making any purchases.)