Health Care: How Much Money Do You Need to Retire?

A couple retiring today would need to have $338,000 in reserve to be certain they could cover their medical costs, estimates the Employee Benefit Research Institute (EBRI). And that figure doesn't allow for long-term care, above-average prescription-drug needs, or the possibility of benefit-cutting changes to the Medicare program. "[Health care] is the No. 1 reason why retirement plans get derailed," says Stacy Hammond of Schwab. "It's the most common reason why people have to go back to work."

The first big health-care shock often hits retirees who leave their jobs before they become eligible for Medicare at age 65, leading them to buy costly private insurance. Near the end of life, a catastrophic illness or the price of long-term care can quickly eat up a family's nest egg. In between, the out-of-pocket costs for prescription drugs and deductibles from doctor's visits can add up.

Cash-strapped and concerned retirees shouldn't count on health-care reform to help with those expenses, either. The current proposals don't address Medicare, the program that most older people use as their primary insurance program. But changes to Medicare will come, says Paul Fronstin, the EBRI researcher who studied health-care costs. And those changes could make retirees (or their bank accounts) even sicker. The Medicare program will become insolvent in 10 years, according to the program's own trustees. Fronstin estimates that changes to put it on a more solid footing could cut benefits in half or double payroll taxes.

To pinpoint just how much their clients need in order to afford both a healthy and an unhealthy retirement, financial advisers use this rule of thumb: assume that most retirees will need to spend about 80 percent of what they are spending now on everyday living. Workers should save 25 times the annual amount that remains after they've subtracted their expected Social Security and pension benefits, in order to make sure they cover their costs.

Hammond also suggests that people use a bottom-up approach to save for health care. Anyone expecting to need private health insurance before Medicare kicks in should price policies now and think about setting aside cash to cover them.

There is one exceptionally good way to save for retirement health care. Health-care savings accounts, which combine a high-deductible health-insurance plan with a savings/investment account, allow savers to set aside tax-free money for future health-care expenses. As of 2009, qualified insurance plans must have deductibles of at least $1,150 for self-only coverage and $2,300 for family coverage and maximum annual out-of-pocket limits of $5,800 for individuals and $11,600 for families. That enables policyholders to make tax-deductible contributions of as much as $3,000 (individual) and $5,950 (family) to health-savings accounts. People 55 or older can contribute an additional $1,000 a year.

Those funds can be saved and invested and carried over from one year to the next, so workers who can afford to contribute the maximum amount and pay their current health costs out of pocket can pile up significant amounts for retirement health care. Withdrawals are not taxed if the funds are used for health care. (If they are not used for health care, they are subject to income tax, and if they are withdrawn before the accountholder is 65 and used for nonmedical expenses, they are also subject to a 10 percent penalty. The Senate Finance Committee's health-reform bill would raise that penalty to 20 percent.)

The next question for savers is how they should invest the money they have earmarked for retirement health care. Most advisers suggest that these savings should be invested as part of a fully diversified retirement portfolio. But an argument can be made that money aimed at future health care could be invested at least partially in health-care companies. This theory holds that those companies will benefit from increased health-care spending in the future, so shareholders may see returns that keep pace with their own rising medical costs. Since 2000, the health-care sector has grown at a faster rate than the gross domestic product, while at the same time medical-care prices have been outstripping the Consumer Price Index, says Alex Morozov of Morningstar, an investment-research firm. He points to both of those developments as indicators that health stocks could outperform the stock market as a whole. In the past year, for example, health-care stocks have risen 10.33 percent, more than triple the 3 percent increase in the Dow Jones industrial average, according to Morningstar data. During that same period, medical care costs have increased 3.3 percent, while the CPI has declined 1.5 percent. And though some people think cost-containment measures in health-care reform could hurt the financial performance of health stocks, expanded coverage could bring more customers to drug- and medical-device makers and medical-service providers. "Health-care companies will benefit from the aging population," says Morozov.

So that aging population can expect to keep shelling out more and more just to stay healthy, as it moves to and through retirement.