One of the essential elements in planning for retirement is estimating how much income from working will need to be replaced once the job is no longer there to provide it.
But what if those estimates are wrong?
That's exactly the problem, says a paper from HealthView Insights.
Income replacement ratios, on which not just would-be retirees but also financial advisors and plan sponsors rely to project how much income a retiree will need to cover his needs, are flawed, because they fail to account for the true cost of health care in retirement.
And that means that estimates based on existing IRRs could come up short at the worst possible time.
The paper says that workers saving for retirement are relying on an IRR that does not take into account the fact that most Americans are only paying 25 percent of their health care costs while working.
Once they retire, they'll be liable for the 75 percent currently subsidized by their employer, and to keep their coverage at all comparable to what they had during employment, they'll have to sign on for Medicare Parts A, B, and D, and buy a supplemental policy as well. Then they'll be on the hook for premiums and copays for any coverage that requires them.
And that's not even taking into account the potential for a catastrophic health event.
In addition, IRRs also assume that household expenses in retirement can be projected forward using the general inflation rate of 2.5–3 percent.
However, with health care costs projected to rise at about 6 percent per year "for the foreseeable future," this means that IRRs are building in a "disparity" that "[o]ver time … will widen the gap between retiree savings and health-related expenditures."
While the most widely used figure for income replacement ranges between 75–80 percent, determined by research that included income data from the Health and Retirement Study, some experts have said that that's not a high enough estimate, particularly for families and individuals who get by on lower incomes, who "spend a larger proportion of their incomes on necessities."
Current IRRs, which do not include such elements as unexpected out-of-pocket medical expenses, accurate health care inflation rates, life expectancy projections, and Medicare means-testing surcharges, aren't going to be adequate to produce sufficient income for retirees to afford quality health care and still maintain the standard of living they have planned for.
Those lower-income individuals and families will need 90 percent or even more of their current incomes during retirement to be able to meet all their expenses, including health care costs.
But it's not just the lower-income tier who will be in need of a higher IRR to be able to be comfortable during retirement, the paper said.
It cited AON Consulting's 2008 Replacement Ratio Study in saying that those in the $150,000–$250,000 annual income range would also have a tough time. "[I]t is becoming difficult for affluent individuals to generate sufficient retirement income based on Social Security and an employer's qualified plan alone," the study said, adding, "These individuals generally require a substantial portion of their retirement income to originate from nonqualified savings."
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