As actuaries, we employ present value calculations in annual spending budget determinations (converting lump sum present values of assets and spending liabilities into annual spending budget streams). While we agree with Mr. Kitces that converting lump sum present values into equivalent annual cost streams can be more meaningful to individuals for retirement planning purposes, we reject Mr. Kitces’ claim that calculating a reasonable lump sum present value of expected future healthcare costs could be considered absurd.
In this post we will:
- Defend present value calculations for planning purposes, and
- Discuss how Mr. Kitces really makes healthcare cost planning more “manageable”
As actuaries, we believe retirement planning should involve:
- making best-estimate (or conservative) assumptions about the future,
- adjusting your retirement plan when your assumptions turn out to be incorrect, and
- using the same lifetime planning period when determining the present values of income items, such as Social Security, as is used in determining the present values of expected expense items, such as medical costs, housing costs, etc.
Therefore, if an individual (or financial planner) selects a conservative lifetime planning period as part of the retirement planning process, this selection will result in a higher present value of healthcare costs for planning purposes, all things being equal. As noted by Mr. Kitces, use of the same conservative lifetime planning period for expected Social Security benefit payments will also produce a higher present value of these benefits for planning purposes. These higher values are consistent with each other and 100% accurate if the “best estimate” assumptions are realized. This same conservative lifetime planning period assumption is also used by many retirement planners to convert a “lump sum” present value of accumulated savings into lifetime retirement income.
Mr. Kitces notes that medical costs have historically increased at a rate faster than general inflation. He says “[Since] medical expenses inflate at their own higher-than-the-general-rate-of inflation (at 3.6% vs 2.2%, respectively, over the past 20 years), arguably health care costs should really be projected separately from the remainder of retiree expenses in analyzing a retirement plan.” We absolutely agree. That is why we provide a separate tab in our single retiree ABC workbook to permit inputting separate increase assumptions for different types of retirement expenses.
For example, if we use all the default assumptions in our workbook, except we assume a 3.4% annual increase in medical costs (1.4% higher than the default inflation rate of 2% as suggested by Mr. Kitces), and we assume a current annual medical cost of $5,200 (the median medical cost for a 65-year old woman with income under $85,000 from Mr. Kitces’ article), we develop a present value of future medical costs for this female of $148,000, or roughly half of the $280,000 present value cost estimated by Fidelity for a 65-year old couple.
Thus, under the default assumptions used in our workbooks and a 3.4% per year increase in medical costs, the calculated lump sum present value of $148,000 for Mr. Kitces’ hypothetical 65-year old female is equal in present value to a stream of annual costs starting at $5,200 this year and increasing by 3.4% each year for 31 years. This $148,000 lump sum present value is the amount that she should have reserved today to fund all of her future expected healthcare costs.
By comparison, if she is currently receiving a Social Security benefit of $1,294 per month or $15,528 per year (the average Social Security benefit from Mr. Kitces’ article), the lump sum present value of this benefit, using the same default assumptions in our workbook, would be about $365,200. When considered together in a consistent manner for planning purposes, both the lump sum present value of the future healthcare costs for this female and the lump sum present value of her future Social Security income seems to us to be perfectly reasonable. Nor would it be any more “scary” or “absurd” than a recommendation from her financial advisor, if she had accumulated savings of $100,000, that such savings might produce only an annual income of $4,000 per year under the 4% Rule.
If these default assumptions and a 3.4% per year increase in medical costs assumption are accurate and this hypothetical female has no other assets at retirement, she can expect to spend about 40% ($148,000/$365,200) of her assets (Social Security benefits) on healthcare costs on average over her period of retirement, leaving 60% of her assets for her remaining expenses. And because of the different rates of increase as she ages, she can expect her healthcare costs to consume an increasing proportion of her Social Security check over time (starting at about 33% [$5,200/$15,528] at age 65 and increasing to close to 50% in her 90s).
Of course, as noted by Mr. Kitces, the present values of assets and spending liabilities do become more meaningful when they are compared with each other and converted into a stream of current and future spending budgets. This is exactly what is accomplished under the Actuarial Approach.
How Mr. Kitces really makes healthcare cost planning more “manageable”
While Mr. Kitces acknowledges that it is reasonable to assume that future medical costs will continue to increase at a faster rate than general inflation, he cites research that shows that total spending in retirement (including real increases in healthcare costs) tends to decline in real dollars as we age, thus justifying planning for level, rather than increasing, real dollar total spending in retirement. By planning for level real dollar total spending in retirement, Mr. Kitces is able to focus on total spending and does not have to worry about the components of expected future expenses and how these components may increase or decrease relative to general inflation increases as individuals age. And this may not be an unreasonable approach. In fact, even though our Actuarial model permits the use of different increase assumptions for different types of expenses, our default assumption is that total expenses increase each year with general inflation—the same approach used by Mr. Kitces. With our model, however, you can override this assumption if you believe a higher or lower increase rate would be more appropriate in your personal circumstances.
Conclusion
Under the Actuarial Approach, the lump sum present value of healthcare costs is an important component of determining your annual recurring spending budget in retirement. If you are retired, it is the amount that you should have reserved today to cover your expected future healthcare costs. If reasonable assumptions are used to estimate this amount, the result, while it may be higher than you like, is certainly not absurd. We agree that streams of future spending budgets developed from reasonable present value of assets and spending liability calculations generally are more meaningful than the lump sum present values of the assets and spending liability components used in the calculations. The Vanguard/Mercer study cited by Mr. Kitces recommends that healthcare costs should be considered as an annual payment stream rather than as a lump sum for “framing purposes.”
We also agree with Mr. Kitces that healthcare costs will vary from individual to individual, and you will probably need to develop your own best-estimate assumptions based on your own fact situation. Whether you consider your future healthcare costs as a lump sum present value or equivalent value stream of annual costs, we encourage you to factor reasonable medical cost inflation expectations into the assumption you use (or your financial advisor uses) to project expected increases in your total future spending budgets.
