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Are you overestimating clients’ health care costs?

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Health care costs are one of the most important variables in any retiree’s financial plan.

The scary part is, for a long time now, medical expenses have far outpaced inflation. The cost of medical care has increased at a rate of 4.5% annually, over the last 30 years whereas broad inflation as tracked by the U.S. Consumer Price Index, has grown at an average of 2.6% per year.

Many advisors build ballooning medical costs into their plans for clients. These plans generally predict that health care, for most retirees, will be clients’ single largest expense outside of discretionary living expenses. Or will they?

A recent study has shown that this might not be the case.

When participants self-report the amount of money they spend on health care services (after Medicare premiums), the median lifetime cost for a retiree from age 70 to death (95 or later) is slightly above $27,000, according to a new study by the Employee Benefit Research Institute.

Over the span of 25 years, this averages out to be just over $1,000 per year. While there are obvious outliers to these results — study participants who lived longer and went into nursing homes had far higher cumulative costs, for example, than those who died at earlier ages — with the median cost being roughly $27,000, there were many participants who had costs far lower than $27,000.

In broadening the study results and accounting for total medical expenses (all out-of-pocket expenses after premiums), the median amount was still just $2,000 per year.

What makes this study more interesting than many others, is that it uses self-reported data and not hypothetical forecasts. Fidelity, for example, predicts much higher costs, estimating men retiring in 2018 will need $133,000 to cover health care costs in retirement, whereas females will need $147,000.

The real-life data found in EBRI’s report shows Fidelity’s numbers will not be experienced by most people. So how should we as advisors be interpreting these studies as we work with clients?

Treat hypotheticals with care
For most of my career, I have been telling clients that health care costs will make up a significant line item in their retirement budget.

Even when I calculate budget projections for clients who are still working, I have been including it as a separate goal in our planning software to ensure medical costs are broken out from discretionary spending. Only then, do people see the impact this has on their plan.

But if these costs were inflated to begin with, then perhaps I’m being too cautious with my clients. What I should be showing them is a continuum of health care costs.

EBRI’s survey showed that at the most extreme, those who die at age 95 or later and experience the most expensive costs (at the 95th percentile), incur $269,000 of cumulative medical costs.

Perhaps I should show clients a range of projections from $27,000 to $269,000, and let them know that there will be a wide range of costs as they encounter medical events in retirement.
For those who are healthy but meet a swift, inexpensive death, these costs will be minimal.

For those who have a prolonged, expensive illness, their costs will be on the high side. While we can project what might happen, projecting over a quarter of a million dollars for this line item might be too cautious for some clients.

In some client financial plans, I have taken the opposite approach. Instead of breaking out health care costs, I have given clients an annual spending target that incorporates all expenses. In using this approach, we have discussed that in some years, some of this discretionary pot will be spent on health care expenses and there won’t be much left over.

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In other years, when health care is not an issue, there will be some fun money left over to spend on other things. In approaching retirement from a “total annual cost” approach, it allows clients to see that they have competing goals and as each year goes by, they will have to spend on a health care goal in order to enjoy a larger discretionary spending goal in the next year.

I explain that the health care expense is always to be expected and never ignored, which reinforces the respect that retirees need to have for health care expenses if they wish to enjoy a long, fun-filled retirement.

Insurers need to get creative
For those looking to purchase insurance to cover care in their advanced years, I have become an advocate for hybrid life insurance and long-term care insurance products. Traditional long term care insurance products have not kept up with the marketplace and are continually becoming too expensive to justify the cost.

One of my clients recently went through this life Insurance and long term care insurance review process, and I was impressed with what the life insurance broker was able to come up with. It involved both my client and his spouse having separate universal life policies with inflation-protected long term care insurance and return of premium riders.

This enabled both of them to create custom policies based on their goals and needs, and also provided life insurance benefits for the other in case care wasn’t needed. I’m looking forward to seeing how this marketplace continues to innovate and come up with solutions to insure against the tail end of the curve in health care costs.

However you decide to portray medical costs in financial plans, it’s important to keep reviewing these numbers and keep them anchored in reality. While health care expenses will go up over time, many of your clients will not need the large amounts of money we are projecting.

Explaining to clients the wide range of costs they could incur throughout retirement will be
important so they can be prepared to sacrifice some goals if needed. Alternatively, it may be an unexpected surprise should these expenses not materialize and they can fulfill end-of-life wishes otherwise seemed out of reach.

This story appears in Financial Planning’s August CE quiz.

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