By Keith Whitcomb

Health issues and the prospect of running out of money are top concerns for retirement investors, according to a Franklin Templeton Investments survey.

And why shouldn't they be?

Fidelity's annual estimate of healthcare in retirement rose to $280,000 for an average couple retiring in 2018. That doesn't even include over-the-counter medications, most dental services, and long-term care.

In addition, when you consider how much is being saved for retirement, you can further understand the concern. Transamerica's 2018 study estimated that close to 60% of boomer households have saved less than $250,000 for all their retirement needs.

So how is this going to work?

Well, let's take a step back for a moment to do a couple of things. First, we need to get inside the calculation of how much money will be needed for retirement medical expenses. Next, we can look into when that money will be needed. Finally, we can check out some account location and product solution possibilities that can be used to pay for those expenses in a cost-effective way.

Averages and You

Before we get into the assumptions Fidelity used to come up with that "average couple" number, here's a word about averages. I had a statistics teacher in college once tell our class that if you had one hand on a hot stove and the other in a freezer, on average you would be comfortable. Please don't try this at home.

Point being, the use of an "average couple" may be far from appropriate when you are determining what you should do with your finances. With that said, let's take a closer look at cost estimates for retirement healthcare.

Healthcare Cost Assumptions

Assumptions are made whenever financial estimates are calculated. It is important to pay attention to those "numbers behind the curtain" to figure out whether the estimate is relevant for your situation. The Fidelity Health Care Cost Estimate is no exception. Here's a little insight into their assumptions and what it may mean for you.

Confidence: Fidelity presents their results at a "90% chance of being able to pay though life expectancy". This phrase captures two major assumptions. One, you will die at the average life expectancy, a point at which half the population will die sooner and the other half will die later. The second, that you will experience medical costs exceeded by only 10% of the population. That means about 90% of the time, the model shows a need for less money to pay retirement health care expenses. Why use 90%? The problem for all of us is that we are self-insuring this exposure. The conservative solution is to save above the average. However, the result is that by using a 90% assumption, as a group we are effectively saving 40% more than would be needed if we could pool the risk. Well then, why not also use a 90% confidence for mortality? Good question. So, what might be a better way to look at this? We'll get to that in a moment.

Long-term care: Excluded from the Fidelity estimate is the cost of long-term care. Why? Well, Fidelity likely didn't have enough information to estimate it. Does that mean this expense can just be ignored? Absolutely not. So, you will need to include it within your financial plan.

Medigap: Another piece missing from the Fidelity number is Medicare Supplemental insurance (commonly referred to as "Medigap"). Given Medicare co-payments, deductibles, and coverage limitations, many will find it appropriate to purchase Medigap coverage. This is another potential add to your plans.

Taxes: The 5% tax rate assumption used by Fidelity seems low. Using a tax rate lower than what you expect to pay in retirement will reduce the estimated funds needed to cover health care costs. By using tax-free Roth and health savings accounts (HSA), or by drawing on a Home Equity Conversion Mortgage (HECM), you may be able to pay an average of 5% on your retirement income. However, if you are principally relying on traditional IRA, 401(k), and/or brokerage accounts, it is likely you will experience a tax rate higher than 5% given that initial marginal rates currently start at 10% and go up from there.

Asset Allocation: Fidelity assumed an asset allocation of 30% equity, 50% bonds, and 20% cash. This is a conservative portfolio that likely had a low rate of return. If your portfolio asset allocation is more aggressive and on average produces higher returns, your estimated cost will be lower.

Area of Residence: Fidelity also notes that where you choose to live will have an impact on your retirement medical expenses. While not specific to healthcare, has calculated how long $1 million will last if used for all of your retirement needs, based on the state of residence. In a high cost state like California, it was estimated to be 15 years. In a low-cost state like Mississippi, the estimate was over 25 years. You'll need to take this into consideration as well.

So, what's the take away here? Most importantly, unless you fit all the assumptions, the value of advice from a financial model can be limited or even unusable. As a general rule, a model that produces a single estimate based on a large number of highly sensitive assumptions will likely be irrelevant for you. To overcome this problem, you need to move beyond the use of generalized averages and one-size-fits-all estimates that are regularly reported in the media.

A Solution for You

One way to overcome the average problem is to use a range of expected outcomes with different levels of confidence to get a feel for the sensitivity of output results. The Employee Benefits Research Institute (EBRI) does just that in a number of studies it produces. Here's an abbreviated look at some of their research and how it can be applied to your individual circumstances.

Healthcare insurance: Isn't Medicare free? Well maybe Part A, but not Parts B or D. In fact, Part B and possibly Part D premiums will be automatically deducted from any Social Security benefits you receive. Add in out-of-pocket drug expenses and Medigap premiums and you can start to get a handle on expected costs. So how much will that be? Let's take a look.

Long-term care: Below is a table that shows the different services that all are classified as long-term care, and a range of the average costs by state. An image of a map of the United States with color coding for each state's median cost can be viewed online to help visualize low- and high-cost regions.

The biggest exposure associated with long-term care is residing in a nursing home. So, what is the likelihood and cost associated with that happening? Shown below are some ranges of estimates from EBRI.

So, what are the takeaways from these tables? First, there are many flavors of long-term care. As a result, the conversation needs to become quite granular in order to adequately plan for your health care in retirement. In addition, as observed by EBRI, "the majority of retirees do not incur any out-of-pocket (OOP) nursing home expenses... irrespective of the age of death, median OOP nursing home expenses are zero. This means at least half of all retirees do not incur OOP nursing home expenses." Another conclusion is that only a few retirees will experience catastrophic expenses as seen by the dramatic OOP increases at the 90th and 95th percentiles.

A Tale of Two Cash Flows

Now that future medical expenses have been expressed in confidence ranges as single dollar amounts at retirement, you can begin to individualize cost estimates within your planning process. The next step will be to determine when those expenses will be paid. Along those lines, in June of 2018, Vanguard released a report which concluded that health insurance premiums and out-of-pocket costs should be evaluated separately from long-term care expenses. This process of better matching assets with liabilities will help optimize your portfolio's account location, product selection, and asset allocation to effectively meet your health care needs in retirement. How does it work? Let's take a look.

Healthcare: Medicare and Medigap insurance premiums can be characterized as consistent and relatively predictable annual payments. They are not prone to dramatic swings from year to year. So, while retirement income needs may fluctuate, Medicare is a known and non-discretionary ongoing expense. Take advantage of the nature of this liability and the fact that current and historical premiums are readily available as you develop your retirement funding plan.

Account Location Suggestion: While the HSA was polled as the least popular (7%) alternative to fund health insurance premiums in retirement, it is the most tax-efficient. The "triple tax" advantage of the HSA can result in 60% more value than a 401(k) according to research presented by the Plan Sponsor Council of America. Given there are currently over 23 million HSA account holders and that the total is expected to grow, the option of investing for retirement in an HSA may be available to you now or in the near future.

Long-term Care: The cash flow associated with long-term care expenses is unpredictable and can range from a non-event to catastrophic. As a result, this exposure is really best managed by using an insurance product. The next question is which product is a good fit for you, if one in fact exists.

Here are some options to consider.

Product Suggestion: There are a number of long-term care (LTC) insurance products on the market. Traditional long-term care has monthly premiums which over time may escalate as you age. A positive aspect of the product is that the premiums can be paid with HSA savings. This can significantly reduce the after-tax expense of the LTC coverage.

However, similar to other insurance products, if the coverage isn't used, the perception can be that the premiums were a waste of money. A product response to this issue is the hybrid policy. Hybrid long-term care insurance uses life Insurance within the product to eliminate the complaint of getting nothing if the policy isn't needed for LTC. The policy pays a death benefit if the LTC coverage goes unused. There are two flavors of hybrid plans, life insurance with an accelerated death benefit rider, and life insurance with a long-term care rider. These products are complex and may require a significant up-front single premium payment. There may also be suitability requirements, so you will need to talk to a sales person to determine whether this product is a good fit for you.

As more boomers head into retirement and start paying income taxes associated with RMDs on traditional IRA and 401(k) accounts, it will become increasingly clear how important account location and product selection is relative to net spendable income in retirement. To avoid tax inefficiencies, you need to make well informed choices during your asset accumulation years. You need to understand the nature, timing, and size of your income needs in retirement. To be successful, stay away from using broad averages with multiple underlying assumptions unless there is no alternative or the assumptions actually fit your profile.

When evaluating retirement medical expenses and long-term care premiums, the HSA is by far the most tax-advantaged account location available. However, for many it may not be economically feasible (given low contribution thresholds) or even available (you must be enrolled in a high deductible health plan to make HSA deposits).

From a product standpoint, the nature and structure of Medicare premiums makes them well suited for a range of investment approaches designed to generate consistent annual cash flows. An annuity might also work for these payments. In contrast, the insurance end of the product spectrum may be more suitable for long-term care needs. However, a health assessment can be required to determine pricing and availability. This may eliminate LTC insurance as a viable option for you.

The conclusion is that choosing investments and insurance is an evolving journey given ever-changing taxes, product development, and life events. Perhaps the only universal advice is to seriously consider the use of a qualified adviser to help you navigate through these financial decisions.

About the author: Keith Whitcomb MBA, RMA is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.

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