Are Rising Health Care Costs Creating a Retirement Crisis?

By Andrew G. Biggs 

Progressives are proposing expensive expansions of Social Security, but the retirement crisis is overblown.

It’s almost taken for granted that Americans are dramatically undersaving for retirement. Some headline-generating studies claim that half of Americans will fall short of what they need; others say it’s two-thirds or more. And, these studies claim, it gets even worse when we take rising health costs for retirees into account. Facing a seeming retirement crisis, progressives propose expensive expansions of Social Security, despite the program’s multi-trillion-dollar unfunded liabilities. In reality, though, the retirement crisis is overblown. And the claim that health costs mean we need to save dramatically more for retirement shows a misunderstanding of the basics of retirement planning.
The Social Security Administration maintains the best-developed, best-funded, and most widely vetted model of retirement security. The SSA model projects that “replacement rates” for the supposedly undersaving Generation X will be no lower than for Depression-era birth cohorts who retired in the “golden age” of traditional pensions and generous Social Security benefits. SSA’s model estimates that the typical Gen-Xer will at age 67 have an income equal to 110 percent of his career-average pre-retirement earnings, adjusted for inflation. The median replacement rate for the so-called “Depression Babies” is practically the same, at 109 percent. These aren’t exactly panic-inducing numbers.

The SSA projects that 'replacement rates' for the supposedly undersaving Generation X will be no lower than for Depression-era birth cohorts.

The obvious response is that these figures ignore rising health care costs. For instance, an AARP research paper concluded that including health costs reduced the typical retiree’s replacement rate by 10 percentage points. And the Center for Retirement Research at Boston College, which publishes the Retirement Risk Index, argues that including health costs in retirement raises by 38 percent the number of Americans who are “at risk” of an inadequate income.
But these claims focus only on health costs for retirees, ignoring the fact that health premiums and out-of-pocket costs are rising even faster for working-age households. Once you count both sides of the equation, the claim that rising health costs require higher retirement saving makes little sense. This doesn’t mean that health costs aren’t a problem. But they aren’t a problem that saving more for retirement or expanding Social Security will solve.
In simple terms, retirement planning is about saving enough to have the same standard of living in retirement as when working. Economists call this “consumption smoothing.”
How do health costs play into these calculations? According to the Census Bureau’s Consumer Expenditure Survey, in 1989 the typical household over age 65 spent $3,942 (in 2012 dollars) on health insurance premiums, medical services, prescription drugs, and medical supplies, equal to 11.5 percent of after-tax income. By 2012, households’ health spending had increased by 30 percent to $5,116. But retirees’ incomes increased as well. As a result, health spending was practically unchanged at 11.6 percent of after-tax income. If health spending stays constant as a percentage of retirement incomes, there’s no reason that retirement saving should rise as a percentage of pre-retirement incomes.

This doesn’t mean that health costs aren’t a problem. But they aren’t a problem that saving more for retirement or expanding Social Security will solve.

In fact, you might actually argue that working-age households should be saving less. Back in 1989, the average under age-65 household spent $2,249 (in 2012 dollars) on health costs, equal to 3.9 percent of their after-tax incomes. From 1989 to 2012, health spending by households under age 65 rose to $3,121. Since household incomes didn’t keep up, health spending rose to 4.5 percent of after-tax income.
If health costs in retirement are a steady share of incomes and health costs while working are a rising share of incomes, this would point toward lower, not higher, saving for retirement. Granted, the differences are small and there are other reasons – such as longer life spans – why Americans should be saving more. But there’s no logic in arguing that we face a health-care induced retirement crisis.
None of this means that rising health costs don’t reduce Americans’ standard of living. Since higher health spending often doesn’t produce commensurate increases in health outcomes, higher health care outlays can mean a lower quality of life. But requiring working-age households to put away more for retirement – either by saving more on their own or by paying more taxes for increased Social Security benefits – won’t solve this problem.
Instead, we should enact policies to either restrain the growth of health spending or ensure that higher spending actually produces better health outcomes. Some might argue that this comes through a top-down, expert-driven approach, while others (including me) opt for consumer-driven health plans that encourage greater cost-consciousness. But the broad point is simply that if rising health costs are the problem, the solution lies in policies that reduce the growth of health costs.
Andrew G. Biggs is a resident scholar at the American Enterprise Institute.