Health care costs in retirement are consistently cited as the single greatest financial worry for pre-retirees and retirees.
Experts, like those at the Employee Benefit Research Institute (EBRI), have quantified the savings needed for a 65-year-old couple at a daunting $270,000 to cover total health care premiums and out-of-pocket costs throughout retirement (excluding long-term care). However, new research from Vanguard, in partnership with Mercer Health & Benefits, suggests that focusing on this large, lifetime lump sum is not only overwhelming but also the wrong way to plan.
The ‘Daunting’ Lump Sum Myth and Vanguard’s New Framework
When an annual recurring expense is framed as a lump sum, it can seem overwhelming and impractical. For example, the average one-person household over age 65 will spend over $580,000 on food, clothing, and shelter over a 23-year time horizon.
In this context, even a large health care savings goal can feel arbitrary. Vanguard proposes a better planning framework that shifts the focus from a single, uncertain lifetime number to annual, personalized expenses.
Forget the Lifetime Number: Focus on Annual, Personalized Costs
Vanguard’s model suggests that routine medical expenses, premiums, and out-of-pocket costs should be treated the same as other basic living expenses: as an annual amount. The median annual health care cost for a typical 65-year-old woman (with a Medicare Supplement Plan G) was estimated to be $5,100 in 2020.
However, based on personal attributes, this cost for a 65-year-old woman could range wildly from $2,700 to $20,100 annually.
Your Health Status is a Retirement Budget Variable
One of the single largest factors influencing your annual retirement health care costs is your individual health status and risk profile.
People with chronic medical conditions consume the majority of medical care services. To account for this, the Mercer-Vanguard model divides retirees into three risk categories: low, medium, and high. High-risk individuals; typically defined as smokers, frequent doctor visitors, or those with two or more chronic conditions incur costs associated with the top quartile.
The 12 Chronic Conditions That Determine Your Risk Profile
The Vanguard model uses a list of 12 chronic conditions to help establish a retiree’s likely health status and future costs. An individual categorized as high-risk could expect costs to be over 40% higher than the medium-risk baseline. The conditions considered include:
Hypertension
Diabetes
Heart disease
Chronic kidney disease
Depression
Chronic obstructive pulmonary disease
Cancer (colorectal, breast, prostate, lung)
Alzheimer’s disease, senile dementia, and related disorders
Why Retiring Before 65 Can Cost You Four Times More
Retiring before Medicare eligibility at age 65 requires a strategy to bridge health coverage.
Without access to employer-sponsored benefits, pre-Medicare retirees must typically use private insurance, often through public marketplace exchanges. The premium cost for a typical Bronze or Silver plan at age 64 is projected to be more than four times the cost of most Medicare coverage at age 65 that is not subsidized by an employer.
For a 64-year-old medium-risk woman, annual costs for a Marketplace Silver plan could reach $16,700 (premium + out-of-pocket).
The Hidden Cost of Retiring: Losing Your Employer Subsidy
A significant cost shock at retirement is the loss of employer health care subsidies. Employers that provide health care benefits spend, on average, about $6,000 per year per worker for employee-only coverage.
Once retired, the individual must cover this cost. For a retiree, the annual premiums for Medicare with Supplement Plan G could be expected to be $3,600, more than double the average $1,500 the employee paid while working under a median-subsidy plan.
The Medicare Coverage Trade-Off: Medigap vs. Advantage
Medicare-eligible retirees face a choice that heavily impacts their annual costs:
Original Medicare only: Used by 9% of enrollees. This option results in the widest range of potential annual health care costs, as it has the lowest median cost but the highest potential variability in expensive years.
Original Medicare with a Medigap plan (e.g., Plan G): Used by 26% of enrollees. This option involves paying higher premiums to reduce the risk of unpredictable, high out-of-pocket costs.
Medicare Advantage Plan (Part C): Used by 37% of enrollees. These private plans often provide lower out-of-pocket costs and may include dental/vision, but they restrict the choice of health care provider to a specific network.
The High-Income Tax: Understanding Medicare Surcharges (IRMAA)
High-income retirees face significantly higher Medicare Part B and Part D premiums due to surcharges. As a retiree’s modified adjusted gross income (MAGI) increases past certain thresholds, government subsidies are reduced, raising the premium. For example, in 2020, an individual with a MAGI over $500,000 would pay an annual Part B premium of $5,899, compared to the base premium of $1,735 for those below $87,000.
Assessing the Long-Term Care Need: The “Unpaid” Factor
While the probability of needing extended care is relatively low, the magnitude of the cost is hard to ignore. When evaluating this risk, retirees should first assess their access to unpaid options. Spouses, adult children, or willing friends can often provide support for at least a portion of the care required. The availability and capability of this support network can significantly reduce the financial burden of formal care.
Calculating the “Incremental” Cost of Care Facilities
Retirees often fear the absolute cost of a nursing home (which can exceed $8,800/month), but the calculation should focus on the incremental additional cost. Long-term care expenses often substitute for other expenses that disappear during a facility stay. For example, a large travel budget will likely no longer be applicable, and a nursing home stay may negate the need for other housing costs. Planning should focus on the gap between your previous lifestyle expenses and the new care costs, rather than the total sticker price of the facility.
The Medicaid Safety Net and Legal Planning
A catastrophic long-term care event has the potential to deplete assets entirely. Because of this, it is crucial to understand Medicaid rules well in advance of a health crisis. Medicaid acts as a safety net for those who have exhausted their resources. Individuals who believe Medicaid may eventually be part of their long-term care plan should consult with an elder law attorney to navigate the complex asset rules associated with eligibility.
Self-Funding: The “Contingency Reserve” Strategy
The primary source of long-term care funding for most affluent investors is private, out-of-pocket spending. Vanguard suggests explicitly planning for this by separating assets into sources of annual income and a “contingency reserve.” This reserve is specifically for large, unexpected expenses like health care. A retirement plan that spends down a portfolio without holding back a reserve for potential long-term care puts a retiree’s financial stability at risk.
Using Home Equity as a Funding Source
For many retirees, home equity can serve as a vital part of the contingency reserve for nursing home stays. However, this strategy requires caution for married couples. If one spouse enters care, the surviving spouse may still need the home. Therefore, relying on home equity is often more viable for single retirees or as a last resort for couples where the community spouse’s housing needs are already secured.
Understanding Health Savings Accounts (HSAs)
Health Savings Accounts (HSAs) are a tax-advantaged way for Americans with HSA-eligible plans to save for both immediate and long-term medical expenses. Contributing to an HSA can be a strategic move to offset retirement health care costs.
A health savings account (HSA) is an account that can help individuals and families save money for qualified health care expenses on a pre-tax basis. Everyone does not have access to Health savings accounts.
To qualify for an account, you must be enrolled in a high deductible health plan (HDHP). And not all high deductible health plans are health savings account HSA qualified. It has to be defined by the Internal Revenue Service to be an HDHP.
The Internal Revenue Service (IRS) defines an HDHP as a plan with a higher deductible than the typical individual health insurance plans and a maximum out-of-pocket limit that includes deductibles, coinsurance, and copays.
If your employer-sponsored account has additional fees or charges extra to invest, you can open an account with Lively or Fidelity. You can transfer your full or partial balance directly to Lively from your existing provider. Lively will contact your previous provider and handle the transfer on your behalf.
Annuities as “Survivor Insurance”
Single-premium income annuities and qualified longevity annuity contracts can play a unique role in care planning; not necessarily to fund the care itself, but to protect the surviving spouse. A guaranteed source of income that supplements Social Security can lessen the severity of the financial impact if a long-term care event depletes the couple’s liquid assets. It acts as insurance against the poverty of the survivor.
The Limited Role of Long-Term Care Insurance
Long-term care insurance currently pays for only a small portion of care costs in the U.S. Traditional policies have historically been expensive, and benefit caps can reduce their usefulness in the most severe, high-cost scenarios. While new policy types may emerge as the market evolves, traditional insurance remains a relatively small player in the planning space for most retirees.
The 15% Risk and The Case for Separation
Long-term care remains the biggest “wild card” in retirement planning because consumption varies so significantly. Half of the population will incur no costs at all, and a quarter will consume less than $100,000. However, 15% of retirees will spend more than $250,000. Because of this variance, planning for annual health premiums should be distinct from planning for long-term care. By forecasting annual expenses based on personal health attributes and keeping a separate contingency reserve for the “incremental” costs of long-term care, retirees can move away from frightening lump-sum numbers toward a manageable, personalized plan.
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John Dealbreuin came from a third world country to the US with only $1,000 not knowing anyone; guided by an immigrant dream. In 12 years, he achieved his retirement number.
He started Financial Freedom Countdown to help everyone think differently about their financial challenges and live their best lives. John resides in the San Francisco Bay Area enjoying nature trails and weight training.
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