Retiree Medical Costs Are Daunting, but Let's Get the Facts Straight!

Yes, medical expenses in retirement are daunting. The typical analysis, though, misses the mark by comparing apples to oranges. But you can still do this.

Can you save enough in a Health Savings Account to cover your medical expenses in retirement?

Yes, according to some articles in the popular press. But their models contain a major flaw.

Fortunately, even correcting for this flaw, however, it's possible to save enough inside a Health Savings Account to cover these projected expenses. It takes the usual discipline critical to forego spending all your income today, just as saving for retirement, an emergency, a vacation, a home, and a car do. But the math proves that it can be done.

The Flaw

Fidelity estimated that an opposite-sex couple retiring at age 65 in 2021 will incur $300,000 of medical and other health-related expenses in retirement. These expenses include Medicare premiums, Medicare cost-sharing, dental and vision services (mostly not covered by Medicare) and miscellaneous self-prescribed remedies, equipment and supplies, and other items that Medicare doesn't reimburse.

Articles in the popular press cite a current estimated retirement figure and show you how you can methodically save in your Health Savings Account over the course of 30 or 40 years to build your balance to $300,000. Here's an example of one such article, though it uses a spending estimate twice as high as Fidelity's to illustrate its point. We'll apply the author's methodology to the more accepted Fidelity figure in a moment to test the hypothesis that you can save enough to meet projected retirement expenses.

The Fatal Flaw

The fatal flaw in this and similar analyses is time horizons. Let's say you're age 30 this year and open a Health Savings Account that you plan to fund for 36 years to cover your medical expenses in retirement. This year's Fidelity figure is $300,000. So, according to these analyses, you can build a balance of more than $300,000 by contributing $1,950 annually for 36 years and earning an annual return of 7% return on your balance.

That seems doable. Of course, you'll probably deposit more than that. But you need to save (as opposed to spend) that much each year to make the model work. After 36 years, you'll have a balance of $305,600 to apply to your $300,000 of projected expenses.

Do you see the flaw?

While your balances are growing annually with additional deposits and investment returns, so too is the $300,000 figure growing. In fact, at a 4% Medicare inflation rate, the $300,000 figure will grow to $1.183 million in 36 years. Suddenly, your $300,000 balance will cover less than a third of your projected expenses.

Crunching the Real Numbers

You don't have to do the correct analysis. That's why you have me. Here are the results:

• Yes, at 4% inflation, that projection for medical expenses is indeed $1.184 million in 36 years (2058, the centennial of my birth).
• If you save $4,800 ($400 monthly) in Year One, increase that figure by $90 annually ($7.50 monthly) for the next 35 years and earn a 7% annual compound return, your balance at the end of 36 years is $890,000.

That figure looks like it's nearly $300,000 short of covering your expenses. Did we miscalculate? No! The $1.184 million figure remains the same during the 20 subsequent years, since it's a projection at a point in time of future spending that includes annual medical inflation.

Meantime, your $890,000 balance continues to earn a return, even as you begin to spend the account down on qualified expenses in retirement. I've adjusted the annual return downward from 7% to 3% to reflect the fact that you'll become more conservative as return of principal becomes more important than return on principal during your distribution phase.

Medical spending in retirement isn't linear - younger retirees often have lower costs during their early retirement years, then higher expenses later as they age. I adjusted my model to reflect spending 40% of the $1.184 million during the first 10 years and 60% during the final 10 years to reflect the difference in spending over time. This adjustment oversimplifies the pattern, but it gets us to the proper endpoint.

You begin Year 20 of retirement (Year 56 of our model) with a balance of nearly $131,000. That year is important because it's the end of the average remaining lifespan of someone who reaches age 65. That year, you earn $4,000 and spend $71,000 on medical expenses. Your ending balance at the end of Year 20 - after two decades of distributions - distributions is nearly $64,000 - enough to almost cover another year of spending on the two of you (or nearly two years of spending on the surviving spouse) if you live longer than average.

By the way, if longevity runs in your family, you may want to bump your average savings rate to $5,400 ($450 per month) and increase it $240 annually ($20 per month). That extra savings and the returns will carry you through $1.85 million of expenses through Year 67 (age 97 if you start saving at age 30, as our model assumes). You'll even be able to leave a legacy of about $36,000 to a loved one.

The Bottom Line

Beware of any analysis about saving for medical expenses in retirement that calculates future contributions to meet today's projected medical spending after age 65. Your goal is not to spend the next 36 years generating sufficient balances to pay today's retiring couple's projected medical spending. You need to cover your projected expenses in retirement. That figure won't be finalized until you turn 65. Your best bet is to choose in inflation figure to adjust today's number to your retirement date, then backing into annual contributions and balance growth to reach that figure.

You can do it. It's just not as easy as some flawed models suggest.

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