The Finance of Retirement

Income replacement ratios, health care inflation, and saving for adequate income

by Ron Mastrogiovanni

Mr. Mastrogiovanni is president of Health View Services, in Danvers, Ma.
Connect with him by e-mail:, and visit

As Americans age, the question, “How much money do I need to retire?” becomes fairly common. This inquiry also carries a subjective element and should probably be rephrased as, “How much money will I need to maintain my desired lifestyle after I stop working?” With the complexities of today’s economy, the volatility of American and global markets, and steadily rising health care costs, producing a viable answer has never been more difficult.

The current method that many financial services firms, advisors, and plan sponsors use to help clients estimate necessary retirement income is the income replacement ratio (IRR). The concept of income replacement ratios is relatively straightforward: analyze the expenses and income of working individuals to create a percentage of how much annual revenue will be needed during retirement. For someone earning $100,000, an income replacement ratio of 80% means he/she will need to save enough to generate $80,000 a year during retirement.

This number is not arbitrary. Retirement experts and academics have spent a considerable amount of time developing the ideal IRR, and the general consensus is that replacement ratios should fall within the 75% to 85% range of pre-retirement income (generally based on the final year of employment). These percentages are determined by adding 2.5% to 3% to annual income (to account for underlying inflation) within a span of five to ten years before retirement, which creates the baseline for the IRR calculation.

These ratios, and particularly the amounts they represent, may sound somewhat excessive to advisor clients or 401k plan participants, but they are designed to address inflation, expected taxes, withdrawals from savings to generate income, and lower average returns from the diminishing value of retirement assets – all of which must be factored into the income calculation.

While 80% is commonly used as a “top-down” rule of thumb, advisors can also utilize a “bottom-up” approach, which provides more specific calculations of projected expenses in retirement. Based on individual lifestyle choices, a bottoms-up approach may uncover that a 65% IRR can work for some retirees, but others may need 90% or more.

In fact, a growing number of experts are advocating for even higher IRRs. Brian Knestout, Counsel to the Federal Reserve Board, recently cautioned that because of longer lifespans, using 75-85% may be dangerous because retirees who no longer face workplace constraints tend to overspend by as much as 10% during the first few years of retirement.
While a bottoms-up approach is likely to be more accurate than using a simple top-down 80% ratio, there is one area in which both strategies place retirement plans at risk of being underfunded – future health care costs.

Income Replacement Ratios and Health Care

Before we highlight the IRR and health care cost issue, let’s establish that anyone who is participating in a consistent long-term investment strategy is ahead of the game. In fact, those who use income replacement ratios as a planning tool already include a portion of retirement health care costs in the overall picture.

The question is: “How much extra will retirees need?” As a starting point, let’s remind ourselves of the basic assumption behind IRRs – essentially that a percentage of pre-retirement costs can be projected forward into retirement. This works if costs are comparable and the inflation rate used to project these costs is accurate.

Unfortunately, health care costs are less than ideal for a direct comparison because there is a variance among pre- and post- retirement medical expenses. Also, IRRs are calculated with the assumption that workers typically pay 25% of group health insurance premiums and 100% of other out-of-pocket expenses. Unfortunately, while most Americans mistakenly believe that Medicare will cover all retirement health care costs, the true number is closer to 50%. The majority of retirees will not only have to pay for Medicare premiums, but also supplemental insurance premiums and other out-of-pocket costs as well. To summarize, health care costs in retirement are not directly comparable to pre-retirement health care costs.

because of longer lifespans, using 75-85% may be dangerous because retirees who no longer face workplace constraints tend to overspend by as much as 10% during the first few years of retirement

Another weakness is that IRRs use an underlying inflation rate of 2-3% to project costs going forward. HealthView’s “2015 Health Care Cost Data Report” shows (based on actuarial data) that health care inflation will rise by approximately 6% per year for the foreseeable future, effectively double the underlying inflation rate in most IRRs.

Increased longevity will also translate into higher out-of-pocket costs that are not built into most IRR calculations. Lastly, for wealthy individuals, the assumptions underpinning income replacement ratios do not include the impact of Medicare means-testing surcharges.

These concerns are not merely academic points. Driven by inflation and increased cost sharing, health care costs, which were once a manageable line item, are on track to steadily consume a larger portion of retirement budgets. This is a real issue for the millions of Americans who currently assess their financial futures on projections that will fall short of their actual needs in retirement.

The fact is health care is emerging as one of the largest expenses in retirement. While we analyze these cost components further in our upcoming white paper, it is fairly safe to presume that those using IRRs may see a large difference in overall health care expenditures before and after retirement.

The next question for firms, advisors, and their clients using IRR-based tools is, “What is the likely shortfall when projected health care costs are built into retirement plans?” Based on preliminary data for HealthView’s new white paper, the gap is actually manageable.

IRRs and The Retirement Health Care Cost Gap

Let’s examine a 55-year-old male retiring at 65 with a life expectancy of 85. Coverage includes Medicare Parts A, B, D, a Medicare supplemental plan, and all out-of-pocket costs excluding vision and dental. (All totals are based on the national average and presented in future dollars.)

As the table (above) indicates, someone without a retirement savings plan will need a lump-sum investment of $83,365 to pay for future health care costs. If this person had maintained a long-term investment strategy with an advisor who utilized IRRs, he would only be faced with a $16,777 shortfall. Thus, with an additional $2,150 annual investment, (or $180 per month) over ten years generating a 6% return, this 55 year old would be able to significantly reduce his long-term exposure to unexpected medical expenses.

On a broad scale, future retirees who have maintained investment plans that employ an IRR-based approach are much less likely to be blindsided by health care expenses, which will ultimately allow for more control over retirement budgets.
So what are the takeaways? Ultimately, individuals who want to maintain their desired standard of living beyond their working years will need to save more to cover health care costs not accounted for in IRR-based plans. The silver lining is that Americans who use IRRs are already covering a portion of expected costs and will only need to modestly increase their projected IRR by a few percentage points to close the health care cost gap and enjoy long-term financial security in retirement.

From an industry and advisor perspective, we have been seeing compelling evidence that client conversations about issues regarding retirement health care costs lead to increased savings and stronger relationships: a win for companies, advisors and clients. ♦