The Biggest Risk to Your Retirement

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
Updated October 28, 2009

After years of planning and saving for retirement, the last thing you want is for unexpected medical bills to undo your hard work. But there's no bigger threat to your retirement than a serious illness. Without adequate health insurance, even a relatively minor hospital stay could derail your finances. A major illness could be financially devastating.

The good news is that there are steps you can take now to mitigate the risk that health care problems in retirement could decimate your plans, or those of your loved ones. If you're working, you likely have insurance through your employer or under the umbrella of a small business. But the rules of the road change in retirement, when you may need to obtain individual health care coverage until you become eligible for Medicare at age 65, or to supplement it afterwards.

Here are some insurance options to consider now:

Private health insurance
Not all policies are created equal—try to choose one that matches your needs and ability to cover certain costs on your own. Costs may vary by the state you reside in, family status, health and lifestyle (are you a smoker or in a high-risk occupation?), as well as coverage levels, coinsurance, deductibles, copayments and other factors.

If you're under 65, compare the cost of continuing your medical and dental coverage with your former employer (for up to 18 months through the federal COBRA program) with the cost of insurance you might be able to obtain on your own.

In addition, most states have programs that will allow you to extend COBRA coverage. For example, eligible California residents have the option to extend COBRA coverage an additional 18 months. Those 60 or older who have been with their employer for at least five years can extend COBRA coverage until they turn 65.

Also, remember that you were probably already paying a significant portion of your health insurance premiums at work through payroll deductions. For example, if your employer was deducting $135 every two weeks, you were already paying $3,500 a year. If that's the case, you would only need to budget an extra $4,000 if you bought a new policy costing $7,500 a year. Of course, you could pay your insurance costs out of your retirement cash flow. Or, you could begin saving now to ensure that you have enough set aside. But keep in mind, because increases in health care costs tend to significantly exceed the normal rate of inflation, you can't simply rely on retirement savings rules of thumb (see "Calculating the Costs").

Calculating the costs
How much money you'll need to cover health care costs in retirement depends on several key unknowables—how much health care you'll need for how long and the inflation-adjusted return on your money. Because of fast-growing costs, we assume a health care inflation rate roughly triple the projected Consumer Price Index.

To illustrate, let's assume:

First-year costs = $7,500
Health care inflation rate = 8%
Rate of return on lump sum = 7%
Time horizon = 30 years

We did the math,* and you'd need a lump sum of about $260,000 at the start of your retirement to cover your costs for 30 years. If you assumed 25 years, you'd need about $210,000. Or, with first-year costs of $10,000 and a 30-year horizon, you'd need about $345,000.

Remember, these calculations are a hypothetical example and don't account for the reality that investment returns fluctuate. Using a sophisticated Monte Carlo simulation assuming a moderate portfolio return, we estimate you'd need about $360,000 to achieve a 90% chance of being able to pay retirement health costs of $7,500 in the first year, rising 8% a year for 30 years.

Estimating your potential retiree health care costs now can help you plan properly for your future.

*The formula is for the present value of a growing annuity: $7,500 [(1 – ((1.08) ÷ (1.07))30) ÷ ( –0.01)]1.07

Health savings accounts (HSAs)
HSAs combine high-deductible health insurance with a tax-free savings account that can be invested as you see fit, similar to an IRA. You choose a sum you're willing to pay out of pocket for medical expenses. The insurer pays most of the bills over that amount. You meet your own costs by making tax-deductible contributions to the HSA and using that money, tax-free, for qualified medical bills. For 2009, the annual maximum contribution is $5,950 for families and $3,000 for individuals (individuals age 55 and older can contribute an additional $1,000 "catch-up" amount). For 2010, the limits are $6,150 and $3,050, respectively. Any unspent money stays in the HSA for future use. And there is no annual "use it or lose it" provision, as there is with flexible spending accounts (FSAs).

HSAs work best if you're rarely sick and can build up big reserves, or you can afford to pay medical bills from your current income and will treat the HSA as if it were a tax-favored retirement account. In addition, certain states still do not conform to federal tax rules on HSAs (e.g., California, New Jersey, Wisconsin). So, you'll want to check with your tax advisor about specific state rules regarding these accounts.

Regardless of age, withdrawals from HSAs are tax-free and penalty-free if used for qualified medical expenses. Otherwise, withdrawals are taxable and subject to a 10% penalty. After age 65, however, withdrawals are penalty-free (but subject to income tax if used for nonmedical expenses). To qualify for an HSA, you must:

Have a high-deductible health plan on the first day of the month. For 2009, the minimum deductible for such plans is $1,150 for self-only coverage and $2,300 for family coverage (out-of-pocket maximums are $5,800 and $11,600, respectively). For 2010, the minimum deductibles are $1,200 and $2,400 ($5,950 and $11,900 out-of-pocket maximums).
Have no other health coverage except what is permitted under IRS rules (see page 4 of IRS Publication 969 for details).
Not be enrolled in Medicare.
Not be claimed as a dependent on another person's tax return.

HSAs aren't for everyone. While they may work well for young, healthy employees, HSAs may not be as beneficial for people who'll likely face higher annual out-of-pocket health costs, such as older workers, less-fit employees of any age, or families with kids needing frequent medical attention. Also, high-deductible plans may not make sense for lower-wage earners who can't afford the out-of-pocket expense.

In retirement
If you're 65 or older and in retirement, other options exist:

Medicare: If you're already receiving Social Security benefits prior to age 65, you will be automatically enrolled in Medicare Part A. If not, you should apply for Medicare three months before your 65th birthday. For everything you ever wanted to know about what plans are available, plus details about coverage, costs and how to enroll, see Medicare and You on www.medicare.gov.
Medigap: Coverage options are set by law. While prices vary by program and state, your total premiums (Medicare and Medigap) will likely be less than what you were paying prior to age 65. For information on selecting an appropriate policy, see Choosing a Medigap Policy: A Guide to Health Insurance for People With Medicare on www.medicare.gov.

Long-term care insurance
The cost of this care can be staggering. The average daily rate for a private room in a nursing home is $206 ($75,190 a year), and a semiprivate room is only slightly less expensive—$183 a day ($66,795 a year). Home care is even pricier. The average hourly rate for home health assistants is $19, making 24-hour care more than $400 a day, or over $150,000 a year.1 What many don't realize until it's too late is that Medicare doesn't cover a lot of these and other expenses (see table below). And costs keep rising. The American Council of Life Insurers projects a 2.6-year stay in a nursing home will cost about $496,000 in 30 years (roughly $191,000 per year).

What Medicare doesn’t cover
Service	What you’ll pay for:
Acupuncture	Any type of acupuncture
Cosmetic surgery	Cosmetic surgery, unless it’s needed because of accidental injury or to improve the function of a malformed part of the body
Dental services	Most routine dental care and procedures such as cleanings, fillings, tooth extractions, dentures, dental plates or other dental devices
Eye exams	Routine eye exams (refractions) for eyeglasses or contacts
Eyeglasses/contact lenses	Eyeglasses or contact lenses except for intraocular lenses following cataract surgery
Nursing home care	Custodial care, like help with bathing or dressing, when it’s the only kind of care you need
Physicals	Routine annual physicals, except the one-time “Welcome to Medicare” physical exam
Medical supplies used at home	Common medical supplies like bandages and gauze
Transportation (routine)	Transportation to get routine health care
Health care outside the U.S.	Most health care while you are traveling outside the United States
Source: “Your Medicare Benefits,” www.medicare.gov.

On the other hand, according to the National Association of Insurance Commissioners, most people over 65 (about 59%) don't spend any time in a nursing home. Furthermore, the average stay for those who do enter a nursing home is only about 2½ years. Though you may never need it, if you're near or in retirement you might consider long-term care insurance, which covers medical and nonmedical care for those with a chronic illness or disability. This insurance may be particularly attractive if you have insufficient assets to self-insure but a net worth too high to receive Medicaid.

If you do opt for this additional coverage, note that premiums can vary widely, depending on age and coverage, and tend to be most cost-effective for those between 50 and 65 who are in good health. Read the fine print to determine what's covered—skilled nursing, custodial care, assisted living? Also ask yourself: What medical conditions qualify for benefits? How long before they kick in? How long will they last? What's the maximum daily benefit? Is there inflation coverage? How solid is the insurer? And what's its history with regard to long-term health care policies? Look for a policy that is guaranteed renewable with locked-in premium rates.

Finally, we recommend you seek out objective sources of information, such as your state insurance commission. For example, California provides consumer information and a handy premium calculator. Or check out A Shopper's Guide to Long-Term Care Insurance, produced by the National Association of Insurance Commissioners. As with all your health care choices, it's also wise to check with your insurance broker, professional associations or affinity groups like the American Association of Retired Persons to compare costs and benefits.

1. Corporate Insight, 2007.

Important Disclosures

The example provided is for illustrative purposes only and is not intended to represent results you should expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(1009-11085)

Return to Top

Take action

Call a Schwab investment professional at 866-232-9890
Visit Schwab Real Life Retirement™ Services

November Market Snapshot
With Liz Ann Sonders

What's around the corner?

Watch now