Medicare, the Biggest Threat to Our Retirement Standard of Living

A recent column predicted that seniors would get the largest Social Security benefit increase in 25 years next January--- about 6 percent. It quickly drew fire from older readers. The 6 percent increase, they pointed out, was before the deduction of the hefty Medicare Part B premium. The premium increase, they said, would wipe out much of the benefit increase.

Actually, it has been that way for decades.

Medicare premiums have increased about 4.6 percent a year faster than inflation. That’s a problem for seniors. It’s an even greater problem for the young who will pay premiums in the distant future. Indeed, their annual future premiums are likely to be greater than what they pay annually in federal income taxes and employment taxes, combined, during their working career.

You can understand why by revisiting the Graveses, the young couple we introduced last week. They were recently married, both 30, living in Delaware and planning to have two children. They intended to send them to moderate-cost colleges. They had a combined income of $75,000 and had recently purchased a $300,000 house with a $60,000 down payment. One of them, Sandy, earned $50,000 and contributed 3 percent to her company 401(k) plan, which was matched by her employer. Conservative, they planned to earn 6 percent on their savings, a real return of 3 percent after inflation of 3 percent. They hope to be pleasantly surprised if they earn a higher return.

As you’ll soon see, it will take a much higher return just to cope with soaring Medicare premiums.

When we calculated the standard of living the Graveses could sustain now and in retirement last week, we made the incredibly benign and totally unjustified assumption that Medicare premiums would rise only with inflation. We did this so our figures would be on the same playing field as the conventional wisdom in financial planning. Crazy, but conventional.

That exercise showed that the couple would have discretionary income--- money they could spend on themselves, not their children or their mortgage--- of $29,795 a year until they were 57. After that they could spend $35,353 a year on themselves for the rest of their lives. (They would also have money to pay their taxes, Medicare Part B premiums, and $6,500 a year to cover the cost of operating their home, all in constant dollars.)

But things change if we make the more reasonable assumption that Medicare premiums will rise at their historical rate. They will have less to spend on themselves--- only $27,095. That’s 9 percent less when they are young, and 23 percent less when they are older.

How can this be?

Simple.  By the time they retire at 65, their Medicare premiums will be $12,151, on their way to $16,784 at 75 and $21,146 at 85 all measured in today’s dollars. That money has to come from somewhere. So it comes out of their discretionary income. It reduces their lifetime standard of living. As we point out in our recent book, “Spend ‘til the End” (Simon & Schuster, $26), none of this is considered when the financial services industry glibly tells us that we should target discretionary spending in retirement income at about 80 percent of our pre-retirement earnings.

Can the young couple get out of this pickle by saving more? Not likely, since it would reduce their standard of living while young even further--- or force them to scale back plans to educate the kids.

What can they do?

One option is to shoot for a higher investment return. Unfortunately, it would require a nominal return a bit over 9 percent, net of all expenses, just to cover the historical cost of Medicare increases.

Is that possible? Yes. But it isn’t probable.

One interpretation is tough: Whatever risk you take with your savings, it won’t be enough to compensate for a single government program that is out of control.

Another is stark: The best “investment” every American can make is to do what neither political party will do--- work on fixing Medicare. It isn’t impossible. One possible solution, for instance, comes from the co-author of this column--- “The Healthcare Fix” by professor Laurence J. Kotlikoff (MIT Press, 2007).

Investment Returns versus Medicare Premiums

This table compares the discretionary spending of a $75,000-a-year couple if Medicare premiums rise at their historical rate. It then shows how seeking higher returns can compensate for increases in those premiums at historical rates.
Age 35 45 55 65 75 85 95
Return 6 percent, inflation 3 (Medicare rises with general inflation) $29,795 $29,795 $29,795 $35,353 $35,353 $35,353 $35,353
Same, but Medicare rises at historical rate $27,094 $27,094 $27,094 $27,094 $27,094 $27,094 $27,094
Return 8, inflation 3 $30,301 $30,301 $30,301 $30,301 $30,301 $30,301 $30,301
Return 9, inflation 3 $30,621 $30,621 $30,621 $34,332 $34,332 $34,332 $34,332
Return 10, inflation 3 $30,870 $30,870 $30,870 $39,143 $39,143 $39,143 $39,143


On the web:

Sunday, September 7, 2008: Replacement Bait: Why the 80 Percent Rule is Wrong

Sunday, August 1, 2008: Want a Good Raise? Retire.

Sunday, June 13, 2008: Medicare Premiums and Your Retirement Standard of Living

To learn more about the unfunded liabilities of Social Security and Medicare read

To learn more about consumption smoothing read

The Healthcare Fix on Amazon