How to plan ahead for retirement healthcare costs

Income replacement ratio calculations also fail to capture the higher inflation projected for healthcare. But Mastriovanni still recommends using a ratio-based saving plan. Projecting $425,000 in future healthcare costs, a 55-year-old man with life expectancy of 87 (who plans to retire at 65) could meet those expenses by investing $3,000 annually for 10 years, he says.

“Big numbers scare people, but you can do something about this,” he says.

Maria Bruno, senior investment strategist in Vanguard’s Investment Strategy Group, suggests thinking about the challenge as part of a multigoal framework for retirement.

“One question is what healthcare will cost in terms of premiums and other out-of-pocket costs,” she says. But you might also want to address long-term care risk, she adds.

“Do you want insurance, or do you want to create a bucket of liquid reserves in the event of a long-term care need?” she says. “And how you want to allocate investments in that bucket?”

Long-term care costs also are rising faster than general inflation. Five-year annual growth in the cost of nursing care a private room is 3.5%, according to Genworth’s annual cost-of-care survey.

Does healthcare inflation call for higher equity allocations near or in retirement to keep up? Not necessarily, says Bruno, although she notes that retirees have been more aggressive than what the firm uses in its target date glide path design. Vanguard IRA investors have equity exposure of 60% at age 65, and are keeping it at that level throughout retirement. By contrast, Vanguard’s target date fund allocation calls for a 50% allocation in equities at age 65, falling gradually bottoming at 30% at age 72. researchers have argued against the traditional wisdom of falling equity allocations during retirement. In fact, Michael Kitces and Wade Pfau found that rising stock allocations during retirement can reduce the probability of plan failure and the magnitude of failure in a portfolio–although their arguments don’t hinge specifically on concerns about healthcare costs.

Health Savings Accounts

Some experts think health savings accounts will evolve into a platform for long-term saving to meet retirement healthcare costs.

HSAs are available to workers in high-deductible health insurance plans. The accounts can be used to meet ongoing deductible and other out-of-pocket healthcare costs. This year, plans can have a maximum out-of-pocket cost of $6,550 for individuals and $13,100 for families. Some employers help offset those costs with contributions to the accounts; this year, combined employer-work contributions can be made up to a combined total of $3,400 for individuals and $6,750 for workers with family insurance coverage.

The tax benefits are compelling: Contributions are tax-deductible, investment growth and interest are tax-exempt, and withdrawals spent on qualified medical expenses also are tax-free. (Funds withdrawn for nonmedical expenses are taxed at the account holder’s marginal tax rate; if before age 65, the funds are subject to an additional 20% penalty). HSAs don’t have required minimum distribution requirements, and they are portable–they are individually owned and not tied to employers.

HSAs have been around only since 2003, and thus far long-term investing has taken a back seat to usage of the accounts to meet current expenses–96% have their funds in cash, according to research by the Employee Benefit Research Institute.

And a recent Morningstar study noted that 10 of the most popular HSA plans offer mediocre and high-cost investment options. And just one of the plans was found to be “compelling for use as a spending vehicle and an investment vehicle,” suggesting there is “much room for improvement across the industry.”

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