WASHINGTON | Wed Aug 8, 2012 5:22pm EDT (Reuters) — Even if employees are healthy, medical costs are likely to take up a large and growing percentage of their retirement budget.

So say experts who have crunched the numbers and come up with some frightening estimates of just how much Medicare premiums, drug costs and the occasional illness will set back working Americans.

A healthy moderate-income couple of 45-year-olds can expect to spend $1.7 million on health care over their retirement years, not counting funds spent on dental and vision care, reports HVS Financial, a Danvers, Mass., consulting firm that does health care expense modeling for financial advisers, the insurance industry and more.

By HVS’s calculations, when that couple retires at 66, it should have $122,541 set aside (assuming 8% annual returns) just to cover its medical costs. His firm’s software allows financial advisers to drill down into these numbers; it also offers reports to consumers at its Web site, www.hvsfinancial.com.

Fidelity Investments has reported that a couple of 65-year-olds retiring today on average would need $240,000 banked to pay for health care, but other private firms are circulating even more breathtaking estimates.

Those numbers are big enough to raise questions about how pre-retirees should prepare, and how those who are already retired should manage their finances to cover their health care costs. Here are a few pointers:

-- An individual’s health profile may matter less than their income in terms of how much they ultimately spend. It’s true that some unlucky people have severe and chronic illnesses that drain their household budgets. But many people will insure against runaway costs by buying a high-end supplemental Medigap insurance policy that will cover expenses that Medicare won’t, says Sunit Patel, a retirement health care expert with Fidelity. That makes their health care costs more predictable and manageable.

What may push up health care costs is being wealthy -- Medicare premiums for Part B (which covers outpatient care) and Part D (for drugs) are on a steep scale. Folks at the top of the scale (singles earning more than $214,000 or couples making in excess of $428,000) can expect to spend almost $2 million more in their lifetimes on Medicare premiums, says Dan McGrath, director of funding strategies at HVS.

-- People may want to mentally segregate health care costs during the savings years. Many retirement experts tell people to guesstimate their annual retirement income requirements at 80% of their last year’s working income. That’s a seat-of-the-pants figure that probably overstates most people’s long-term needs and tends to be pretty inaccurate.

But Fidelity’s Patel suggests that many retirement expenses – clothing, travel, food and the like – are somewhat elastic, and retirees can cut down on what they spend. Health care costs are less elastic. He recommends that pre-retired couples plan to accumulate enough for their health care needs (such as his $240,000 for couples figure) and enough other savings and investments to cover roughly 60% of their working income.

Separately, HVS’s McGrath says that health care costs tend to make up 30% of retirement expenses. So a couple saving around $1 million might consider $300,000 of it to be earmarked for health care costs.

-- But people may not want to invest them separately. Setting aside an amount of money mentally to cover medical costs isn’t a bad idea, but treating that pot of money differently may not make sense. For example, it sounds logical to take that money and invest it in health care companies or mutual funds on the theory that it would grow roughly in line with health care costs. But that correlation doesn’t hold up, says Patel. It makes more sense during the working and savings years to keep the money invested as part of a more broadly diversified portfolio.

-- After retirement, retirees may have to manage income. Big income-producing events, such as the sale of a vacation home or large 401(k) withdrawals, could push someone into higher Medicare premium levels. McGrath points out that a couple living on $100,000 of income (including taxable income and tax-free income from items like municipal bonds) would be well below the higher premium limits. But if one of the spouses died, the remaining spouse would be pushed into a higher premium category (which starts at $85,000 for singles) at the same income level.

Couples who expect large 401(k) distributions can start to move that money into a Roth IRA gradually, so it doesn’t produce large bumps in income. Wealthy people who expect to see very high taxable income after they become Medicare eligible may choose to invest in more costly but tax-protected vehicles like life insurance, suggests McGrath. But that would require some serious analysis to see whether the cost of the insurance itself would be justified by the tax and premium savings.

-- There are two kinds of costs to cover. If the bulk of one’s retirement health care expenses will be in premiums, as Patel suggests is true for the majority, then it makes sense to manage retirement income so that it is there for those monthly payments. That might mean setting aside enough money in a low-cost and inflation-protected fixed annuity to cover monthly payments. But if someone ends up with lesser coverage and risk large out-of-pocket costs for medical disasters, then they would be better off leaving more of their money invested and under their own control, so they could withdraw large chunks if an unfortunate event hits.

-- None of that solves the long-term care problem. Anyone who becomes chronically ill or frail enough to need help with the activities of daily living – bathing and eating and the like – will need buckets of money to cover care in home or in an assisted-living facility. With companies leaving the long-term care insurance business in droves, coverage for that is getting harder to find and more expensive. Right now, that’s a problem without a good solution for most people. Another plan, for another day.

(Editing by Steve Orlofsky)

© 2011 Thomson Reuters. Click for Restrictions.

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