Breaking down health care expenses in retirement

A recent survey¹ from T. Rowe Price finds that health care costs are the top spending concern of retirees. This comes as no surprise as some studies predict that a 65‑year‑old couple may need up to $351,000² to cover health care costs in retirement. But these estimates don’t provide an accurate picture of what most retirees will encounter.

Such daunting numbers give an impression that it will be difficult for most retirees to afford health care in retirement. We believe that planning for health care costs in retirement can be made simpler by using the available assets and income that retirees have. But we need to approach calculating health care costs differently.

When trying to plan for future health care expenses in retirement, consider these three things:

In our view, approaching health care costs as an annual expense makes it easier to plan for them. Any type of expense incurred over a 20‑ to 30‑year period can look daunting when summed up. We might balk at the thought of prepaying an $86,000 cable bill in retirement,³ but that’s not how we pay for cable. Similarly, estimating cumulative future health care costs is not useful because we don’t prepay for health care.

Premiums are relatively stable, but out‑of‑pocket expenses are not. Usually, retirees pay a fixed monthly premium, but out‑of‑pocket expenses can vary from month to month.

As Figure 1 shows, Medicare premiums with prescription drug coverage account for between 73% and 81% of annual health care costs for the majority of retirees, regardless of the type of Medicare coverage they have.

Given that month‑to‑month premiums are fixed and premiums make up the bulk of annual health care expenses, most of the annual health care expenses are predictable. So they can be budgeted for and paid from monthly income.

On the other hand, out‑of‑pocket expenses can vary greatly from individual to individual and from month to month. Figure 2 illustrates how out‑of‑pocket expenses can vary.

It is clear from Figure 2 that out‑of‑pocket expenses are highly variable, and they are the primary source of uncertainty in health care expenses. We believe maintaining an account (like a savings account) with enough liquid savings to meet the annual out‑of‑pocket expenses, and replenishing it annually, might be a good way to address the uncertainty of out‑of‑pocket expenses.

Most of the estimates regarding retiree health care expenses assume a single type of coverage, which may differ from yours. Also, the astronomical health care cost numbers often correspond to a few unfortunate people who experience very high expenses for a prolonged period. Most retirees won’t be in that situation.

According to our estimates, half of retirees with traditional Medicare (Parts A and B), a prescription drug plan (Part D), and Medigap will spend less than $900 per year on out‑of‑pocket expenses. Only 1 in 10 will likely spend more than $4,200 per year on out‑of‑pocket expenses. Also, it’s not necessarily true that someone spending $4,200 in out‑of‑pocket expenses this year will keep doing so for the rest of his or her life.

Prior to retirement (and filing for Medicare), consider:

It’s hard not to be intimidated by extreme estimates regarding future health care expenses. But recognize that your actual health care expenses will be a combination of regular, predictable expenses that you can budget for and, for most people, a smaller component of variable expenses that you can manage from your savings.