A Prescription to Pay Retiree Health Costs

EDITOR'S NOTE: This article was originally published in the January 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

You think you've done a pretty good job calculating your expenses in retirement, from utilities to taxes, from groceries to entertainment. But how realistic is your health care line item?

This will hurt a lot: A 65-year-old couple who lives until 92 can expect to spend nearly $400,000 in out-of-pocket medical costs, assuming a 6% annual health care inflation rate, according to Fidelity Investments. What's worse, this number does not include long-term-care expenses. (Plug in your own numbers at Fidelity's calculator at https://powertools.fidelity.com/healthcost/intro.do.)

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If that number seems high to you, consider that premiums for Medicare Part B, which pays for outpatient services, a Part D prescription-drug plan and a private Medigap policy can easily run a couple $6,500 a year. Add dental work, vision care, hearing aids and co-payments for drugs -- and then figure in inflation. "People are very surprised that so much of their retirement savings are going toward health care," says Sunit Patel, senior vice-president for Fidelity Benefits Consulting.

These projections are likely to send your blood pressure sky high. But there are strategies to reduce, and pay for, your medical costs if you're prepared. One of the first steps, Patel suggests, is for seniors to get a good idea of their retirement health care number as early as possible "so that they can budget for it appropriately." Two places to start are Medicare.gov, where you can review the costs of Part D and private Medicare Advantage plans, and PlanPrescriber.com to review the cost of Medigap supplemental insurance policies.

Former Boeing executive Henry "Bud" Hebeler, author of Getting Started in a Financially Secure Retirement (Wiley, $27.50), says retirees should keep a liquid reserve for all emergency expenses, including unexpected medical costs. This reserve should not be included in your retirement investment total when calculating your annual retirement spending. Your spending calculations, however, should include the costs of Medicare premiums and other expected health care expenses. (Calculate your own retirement budget on Hebeler's Web site, www.analyzenow.com.)

If you don't have a fixed income stream such as a pension, you could consider an immediate fixed-payout annuity to pay for certain essential expenses, including health care premiums and out-of-pocket drug costs. "The sleep-well-at-night factor is affected by how much guaranteed lifetime income is coming in the door," says Rebekah Barsch, vice-president for retirement strategy at Northwestern Mutual Life Insurance.

If you have a serious illness that could reduce your life expectancy, you could buy a medically underwritten immediate annuity that will provide higher monthly payouts or charge lower premiums.

With these products, also called age-rated annuities, the insurance company will boost payouts because it assumes it will make fewer of them. To qualify, you must have a serious condition, such as heart disease, vascular disease, Parkinson's or lymphoma.

Consider a policy offered by Mutual of Omaha Insurance. Based on current interest rates, a healthy 65-year-old man who spends $100,000 on an immediate annuity could receive lifetime monthly payouts of $550. If the insurer determines, based on his health, that he has a life expectancy of a 70-year-old, he could receive $635. "This is a way for somebody who has a medical condition and income needs to get more-favorable terms than if he went with the standard terms of an immediate annuity," says Yuri Veomett, product performance director at Mutual of Omaha.

To apply, you will need to submit a statement from your physician. The company will determine your expected longevity, based on the severity of your condition, Veomett says. Before you buy, ask your physician if he or she concurs with the age rating.

Here are some other strategies that could ease the pain of a severe case of swollen medical costs.

Insure the risk. A standalone long-term-care insurance policy can protect you against the huge costs of a nursing-home stay, home health care or assisted living. But many seniors balk at the idea of paying premiums for insurance that they may never need. In response, insurers are offering policies that combine life insurance or annuities with long-term-care protection.

A hybrid life insurance policy, for example, would provide a death benefit for your heirs and a pool of money you can use for long-term care. Funds used for care would reduce the death benefit. "It's not use it or lose it," says Michael Reese, a certified financial planner in Traverse City, Mich. "If I don't need long-term care, my spouse gets all the cash tax-free. And if I need long-term care, I have the money."

These products are being marketed to people between 55 and 75 who do not have traditional long-term-care insurance and may now find it too costly. One such product is Mutual of Omaha's Living Care Annuity, which is a fixed deferred annuity with a built-in long-term-care rider. Say you invest $100,000 at age 65. If, at age 75, the annuity value is $125,000 and you need long-term care, the product will pay benefits tax-free up to three times the annuity's value, or $375,000. Covered benefits include nursing-home care, home health care, assisted living and adult day care.

If instead you decide to annuitize, your payments will be based on the $125,000 value; the cash-out value will be $125,000 as well. The insurer will ask you for medical information and could deny your application, but, says Veomett, it's a "simplified form" compared with requirements for long-term-care insurance.

Another twist on the fixed deferred annuity is Liberty Mutual's Freedom Series Builder Annuity. Mark McVeigh, senior vice-president of marketing and distribution, says the product is aimed at someone who needs to save for retirement but also "wants to protect against a series of health-related issues."

When you buy this annuity, you can choose from a menu of three "modules," including one for health care. You can withdraw the money at no charge before the end of the eight-year surrender period if you or your spouse require a stay in a medical facility, are diagnosed as terminally ill, or cannot perform two daily living activities, such as bathing or eating. If you reach the end of the surrender period before needing care, you can allow your investment to grow, turn it into a monthly income stream or cash out. The health module boosts the annuity's cost by 0.10%, McVeigh says.

Many hybrid products are complex and restrictive. You should review any purchase with a financial adviser who is not selling the product.

If you already have life insurance or an annuity, you may be able to tap the policy to pay for health care. Under a new law, current owners can exchange their policies for either a long-term-care policy or a hybrid policy without having to pay taxes. In the past, you first needed to cash out the annuity or life insurance policy and pay tax on the investment gains.

Also, most permanent life insurance policies will allow you to use the cash value or dividends to pay for any expenses, including health care. With many policies, you also can accelerate your death benefits if you are diagnosed with a terminal illness.

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Northwestern Mutual offers the example of a 65-year-old man who paid annual premiums of $1,717 for 40 years into a whole-life policy. The policy has a cash value of $389,012. If he needs money, he can claim the cash value ($68,680 will be tax-free) or take a lifetime annual payment of $27,593. Or the policyholder can stop paying premiums, keep the policy and take dividends in cash rather than reinvesting them.

Sock away cash. If you qualify, a health savings account is a great way to build up a nest egg for health care costs in retirement. Although you can't contribute to an HSA once you enroll in Medicare, you can withdraw the accumulated funds in the account tax-free for medical expenses, such as Medicare premiums, drugs and long-term-care insurance premiums. However, you cannot use the account to buy a Medigap policy. You can tap the account for nonmedical expenses, but you will have to pay tax on the withdrawals.

If you have not enrolled in Medicare and already have an HSA, it pays over the long term to make the maximum contribution. In 2012, the contribution limits are $3,100 for an individual and $6,250 for a family -- plus you get to contribute an extra $1,000 if you're 55 or over. Contributions are tax-deductible or can be made with pretax dollars. To qualify, your health insurance policy must be deemed to be "HSA compatible" and have a deductible of at least $1,200 for self-only coverage or $2,400 for family coverage.

Invest the money to grow over time. Fidelity offers this example. A 55-year-old couple contributes the maximum $7,250 each year (adjusted for inflation) for ten years in a portfolio of 50% stocks and 50% bonds and cash. Assuming average market conditions, they'll likely have $94,000 by age 65 in tax-free money to pay for medical expenses.

Retiree Pat Hanratty and her husband, Mike, have been tapping their HSA for medical expenses since they opened the account two years ago. Over the two years, the Troy, Mich., couple has contributed $9,200 and has spent $6,400 -- on prescription drugs, eye exams, physicals and dental work.

Pat, 64, a retired legal secretary, is covered by a retiree medical plan. Mike, 61, is self-employed. The two will continue to fund the HSA until they enroll in Medicare. "We're not in a high tax bracket, but you have to save every penny you can," she says.

Reduce spending. Whether you're in retirement or approaching it, you can take a scalpel to your health care spending. You can reap big savings without having to delay needed treatments or reduce drug dosages.

If you're enrolling in traditional Medicare, buying a Medigap policy "is an excellent way to keep volatility out of expenses," says Northwestern Mutual's Barsch. You also can find savings each year during Medicare open enrollment by scrutinizing Part D drug and Medicare Advantage plans.

Also make the most of free Medicare services. Backed by research that shows that preventive care as well as exercise and other healthy habits reduce health care costs, Medicare offers free coverage for 20 preventive services. They include an annual wellness exam; screenings for colorectal, prostate and breast cancer; and flu and pneumococcal vaccines.

If you're still employed, your health plan also may offer free screenings and other financial incentives to stay healthy. Many companies provide premium discounts or gift cards to employees who take health assessments and who seek help from a "health coach" to manage chronic conditions, such as diabetes and high cholesterol, says Chad Wilkins, chief executive officer of OptumHealth Financial Services, which administers HSAs and other corporate wellness programs.

You also can save a bundle by using in-network providers. FAIR Health, a nonprofit that keeps a database on out-of-network reimbursement rates, offers the following scenario. Your PPO allows the in-network provider to charge $10,000 for a surgical procedure. The insurance company has a $500 deductible, picks up 80% of the balance and limits your out-of-pocket costs to $2,000. Your total cost: $2,000.

Compare that to an out-of-network provider that charges $15,000 for the procedure. After the $500 deductible, your insurer picks up 70% of the cost up to $10,000. Your total cost: $8,350.

If you're paying out of pocket or face a big co-payment, negotiate on price before any major procedure. It's good to be armed with pricing information. A hospital's sticker price will likely be higher than the insurer's reimbursement. At Healthcare Blue Book (www.healthcarebluebook.com), you can find a "fair price" for surgical procedures, lab tests, doctor and dental services, and even hearing aids. These prices are based on what many high-quality providers in your area accept from insurers. You can also use FAIR Health's Consumer Cost Lookup (www.fairhealthconsumer.org) to find estimated provider charges for hundreds of procedures.

Tap home equity. You can take out a reverse mortgage to pay for expenses, such as home health expenses, dental care or out-of-pocket drug costs. The loan must be repaid with interest when a homeowner dies, sells the house, or moves out for 12 months or more. Tread carefully: If you use a good portion of your home equity early, you might not have enough left, after interest payments, if you must move later into an assisted-living or nursing facility.

The big downside of a reverse mortgage, known as a home equity conversion mortgage (HECM), had been its big upfront costs. But the HECM Saver, which was introduced a year ago, reduced those costs, providing a decent option for cash-strapped homeowners who face steep medical costs, says Barbara Stucki, a vice-president of the National Council on Aging.

The Saver provides a smaller loan amount than the traditional reverse mortgage, called the HECM Standard. But its upfront fees are considerably smaller, and some lenders have eliminated them. The best move for paying medical expenses is to take the money as a line of credit. "If you draw down slowly, you're only paying interest on what you are using," says Stucki.

Stucki warns, however, not to use a reverse mortgage to pay for a spouse's nursing-home costs. With nursing-home fees averaging $7,200 a month, "you are going to burn through equity very rapidly," she says.

Nor is it wise to use loan proceeds to pay for long-term-care insurance premiums. It's a costly proposition: You're paying loan fees on top of premium costs. Plus, if you need to pay premiums for 20 or more years, you could run out of loan money and then need to drop the policy, Stucki says.