Better Information on IRRs Needed

A couple of people shared the new Government Accountability Office (GAO) Retirement Security report with me earlier this month on Income Replacement Rates (or Ratios), thinking I’d be interested, since we issued our white paper on IRRs last year.

The GAO report makes interesting reading, as much for what it says, as what it does not, so much so I wrote a Commentary article for the Retirement Income Industry Association®’s (RIIA®) new interactive website last week

There was a lot to say – so the following is a summary of a longer version which you can read here.

The title summarizes the GAO’s takeaway: “Better Information on Income Replacement Rates Needed to Help Workers Plan for Retirement.”

The report highlights a number of factors that need to be considered when calculating a client’s income replacement rate, the percentage of income workers will require to meet financial needs during retirement.  These include spending patterns, household expenditures, and pre-retirement income.

While the report is comprehensive, one variable is understated: the impact of rising health care costs in retirement. In fact, I am being understated right now. I was frankly shocked at how low the health care cost expectations were in the report. They were so low, that health care was really only mentioned in passing.

The main point of our paper, “Retirement Health Care Costs and Income Replacement Ratios,” was that replacement ratios significantly underestimate future health care costs. In the paper, we highlight some key issues with using IRRs to project retirement health care costs.

The first, when working, employees are generally accountable for approximately 25% of health care premiums. In retirement, without employer subsidies, retirees are responsible for 100% of their medical expenses, which include Medicare, supplemental insurance premiums, and other out-of-pocket costs such as co-pays, hearing, vision, and dental.   Data indicates that an average retiree may have to pay two or three times more for comparable health care coverage than they did while in the workforce.

The HealthView white paper also focuses on health care inflation, which is projected to drive costs higher by approximately 6% per year for the foreseeable future. This estimate is consistent with a year-end summary from the Centers for Medicare and Medicaid, which expects retirees to endure at least eight years of health care inflation between 5% and 7%.

Neither are factored into the GAO report.

The GAO is not alone in underestimating future retirement health care costs. Many in the retirement industry continue to project health care costs forward at the underlying rate of inflation – despite the fact that these costs are growing two to three times faster. And, few understand that IRRs also implicitly underestimate health care costs.

HealthView’s data, which is based on actuarial claims data from 50 million cases and incorporates expected health care inflation (among several other variables), shows health care costs will be dramatically higher than those projected by the GAO. Our latest publication explains in detail why this will be the case.

The GAO report correctly recognizes that if Americans are to rely on IRR calculations, they should be personalized and include health care expenses. When it comes to health care – it is essential that realistic projections of future costs are incorporated into IRR calculations – if we are to meet the standard of having better information that leads to a more valuable IRR-based guide to retirement planning.   Right now, the GAO’s report does not do that.