I had a high school physics teacher who told me more than once, “always be true to your convictions, but prepared to abandon your assumptions.”
At Cordant, we have a conviction for helping our clients make smart financial decisions and working with them to keep their financial lives on track. A key component in helping them make smart financial decisions is creating a comprehensive financial plan that is designed right, and that can be a reliable tool to help them answer questions like: Will I have enough to retire? Can I afford a second home? Should I pay off my mortgage? This is where assumptions come in: in order to create a financial plan, we have to make assumptions about the future, and those assumptions should be based on the best-known information because they can have a dramatic impact on the workability of the plan. If the data and evidence suggest our assumptions are inaccurate, we need to be (as my former teacher would be happy to know that we are) prepared to abandon, or at least adjust them.
The cost of health care, particularly for those on Medicare, is a prime example of a financial planning assumption that gets a lot of new research. This research causes us to evaluate whether our current estimates are ones with which we are still comfortable. With that in mind, I'd like to review our current assumption for health care costs in retirement, consider recent research, and evaluate whether we need to adjust.
Our assumption for health care costs
In our financial plans, we assume an individual on Medicare will spend $4,500 per year in retirement on Medicare Premiums and out-of-pocket expenses ($9,000 for a couple). The basis of our assumptions came from studies like this one performed by the Insured Retirement Institute in 2012, which averaged annual health care spending on Medicare Premiums and out of pocket expenses including prescription drug costs using thousands of individual case studies.
Further, we assume that health care costs will inflate (as they have in recent years) at a higher rate than other expenses. In our model, we assume around 3% inflation for most expenses, but 5% for health care spending. Health care costs have not inflated quite that dramatically in recent years, but as the chart below demonstrates, it has consistently inflated at a higher rate than other costs (inflation across the board has been below historical averages in recent years):
So, what impact do these cost assumptions have on a financial plan?
A significant one: For a couple, 65 today, who wants a financial plan that will work through age 90, we are modeling $429,552 in future spending on health care costs. For a couple planning for age 95, the total is $597,957. This is clearly impactful because these are significant sums of money that are not available for other financial objectives such as, travel, buying a car or paying for a family member’s college expenses.
Is the current assumption still accurate?
Recent research has caused us to reevaluate our assumptions and question whether we should make a change, and in some cases, we may need to. Earlier this year, the Employee Benefits Research Institute (EBRI) Published research projecting the savings needed today to cover health insurance premiums and out-of-pocket costs in retirement. EBRI’s approach to projecting costs particularly resonated with us, because our clients often think about retirement planning starting with the question “how much do I need to save today, to not worry about having enough in the future.”
EBRI used Monte Carlo analysis to account for the uncertainty of how long the individual or couple will live, the rate of return they would achieve on their savings in retirement, and the range of health care costs based on individual cases. And, recognizing the impact and uncertainty around prescription drug costs, EBRI performed separate analysis at the 50th, 75th, and 90th percentiles for prescription drug costs:
EBRI’s projections estimated that a couple, both with average prescription drug expenses, would need to have saved $165,000 today to have a 50% chance of having enough money to cover health expenses in retirement. For a 90% chance of covering their expenses, they would need to have saved $265,000.
However, if the couple were to both have unusually-high drug expenses the savings needed now increases. At the 90th percentile of prescription drug costs, the couple would need $221,000 to have a 50% chance, and $349,000 to have a 90% chance of covering their expenses.
So how does this compare with our assumption?
We’ve boiled the comparison up in the chart below. If we use the couple mentioned above who is planning for Age 95 and given our current health-care-cost assumptions, the couple needs $263,000 today in order to achieve a 90% likelihood of sufficient funding given the risk/return assumptions we use for our Moderate Investment Portfolio—in other words very close, to the $265,000 EBRI projected at 90th percentile for a couple with average drug costs.
As you can see, however, our assumption is short of the savings necessary if we plan for the 90th percentile of drug costs while targeting a 90% likelihood of success. i.e., If a client wants to be prepared for the worst-worst case health-care cost scenarios (worst markets, highest health care costs and highest prescription drug costs), we should be planning for higher costs throughout retirement.
Ultimately, we are comfortable not planning for the worst-worst case described above, but this does mean that we are going to begin having conversations with our clients and understand whether they are comfortable with the current assumption and that they understand the trade-offs of being more or less conservative with this assumption. There are individual cases, where it may make sense given known information to plan for that worst-worst case health care cost scenario. But, we have to weigh that against the risk of being too conservative. In our financial plans, we already are most concerned with whether or not they work in worst markets. Clients are often conservative with inputs such as income, home value, and future spending. If we are too conservative in too many places, then we risk clients not spending money they could have otherwise spent.
As with any modeling, financial planning or otherwise, you get out what you put in—or “garbage in, garbage out” as the saying goes. For health care, and all our plan inputs for that matter, we want agreement from our clients, and we want the assumption to be based on the best-known information—research + individual client context—and when necessary, be willing to adjust.