Generally, when we put together a financial plan for clients approaching retirement, we will split expenses into three big buckets – ongoing expenses, one-time expenses and medical expenses. The reason we break out medical expenses separately is that in recent history, these expenses have increased more quickly than general expenses. On the plus side, though, the system nearly all retirees will use to cover their expenses – Medicare – does a really good job of capping those expenses.*
Capping expenses is particularly important in retirement, as most retirees are on a fixed income. Another way of thinking about Medicare is to use terminology typically associated with employer retirement plans. Many moons ago, most employers provided retirement benefits in the form of a defined benefit pension. The pension guaranteed that the employee would receive a certain dollar amount when she retired, and that income would continue to be received through the remainder of the employee’s life, and in some instances in the remainder of the spouse’s life as well.
In agreeing to such an arrangement, the employer was taking on both the risk that investments wouldn’t perform well enough to fund the pension – meaning the employer would have to increase contributions to cover the shortfall – and the risk that the employee would live a long time. As fee-only financial advisors, we only see a handful of these types of pensions now, and when we do, they are usually a very good deal for the client because they reduce the client’s risk in retirement. Employers, on the other hand, weren’t big fans of the cost and risk pensions entailed, so over time they’ve shifted from defined benefit plans to defined contribution plans.
With defined contribution plans, the employer still makes a contribution to the retirement plan, but that contribution is limited. With 401k plans, the contribution can be limited to the match, which is usually some percentage of the employee’s salary and most of the time, the employer must make a contribution only if the employee makes a contribution. Thus, the amount the employer has to contribute under a defined contribution plan is a good bit less than a defined benefit plan, but as importantly, if investments fail to perform to expectations or if the employee lives longer than anticipated, it is up to the employee and not the employer to come up with the funds needed to fill the gap.
The changes that are being proposed to Medicare are akin to changing the program from a defined benefit plan to a defined contribution plan. Basic Medicare is now designed to cover 82% of healthcare expenses, and the amount covered can be increased via adding a Medigap plan for those participating in traditional Medicare or buying additional coverage for those in Medicare Advantage plans. Thus, the amount of care – the benefit – is guaranteed by the plan and the risks of rising costs are borne by Medicare, not by the participants. As fee-only financial advisors, this makes us happy because it reduces the risk to our clients and it makes our clients’ retirement plans more apt to succeed.
While the outline of what is being proposed is sketchy, it essentially represents a shift to a defined contribution plan in which the government will provide participants with a subsidy they can use to purchase health insurance from private insurers. In year one, the subsidy is meant to cover 83% of total healthcare costs, but as those costs rise – and particularly if the costs spike – there is no guarantee that the subsidy will continue to cover costs. Thus, the risk of rising costs is shifted from Medicare to the plan participants just as shifting from a defined benefit plan to a defined contribution plan shifts risks from employer to employee. It makes planning for retirement more challenging, and for those without the financial wherewithal to cover the increased costs, it may mean foregoing needed medical care.
Medicare’s solvency has improved in recent years, but there is still more work to be done. However, from our perspective as fee-only financial advisors, we hope that whatever solution is ultimately found does not involve shifting additional financial burden to current or future retirees.
*It is important to note that Medicare does not cover all expenses one might typically think of as medical expenses. For a brief overview of what it does cover, check out this article I wrote in 2015.
Thanks to healthcare blogger Richard Mayhew for the idea of framing changes to Medicare in terms of pensions.