Retirement savings based on income replacement ratio (IRR)-based calculators risk falling short of meeting retirees’ goals because IRRs significantly underestimate future retirement health care costs, says a HealthView Services white paper.

The paper, “Retirement Health Care Costs and Income Replacement Ratios,” highlights assumptions built into IRRs, reveals the shortfall in retirement health care savings when using IRR-based calculators and the additional savings required to close this gap.

First, IRR-based calculators assume pre-retirement income is a good basis for calculating income needs in retirement, but HealthView’s research shows, when it comes to health care, this is not the case. IRR-based calculators also assume that household expenses in retirement can be projected forward using the general inflation rate of 2.5% to 3%; however, since health care costs are expected to rise at approximately 6% a year for the foreseeable future, IRRs will fall short on the savings that will be required to cover health care.

“IRRs provide financial professionals with a streamlined, top-down approach of assessing retirement savings and income goals without having to calculate and project individual line-item expenses,” says Ron Mastrogiovanni, founder and CEO of HealthView Services. “If they have saved for retirement using an IRR, most Americans assume they will have sufficient savings to cover their major costs. Many are in for a surprise when they find out that IRRs only cover a portion of estimated future health care expenses.”

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“In fact, most employees only pay around 25% of their actual health care premium costs, while employers pick up 75%. In their first year of retirement, for comparable coverage, they will have to pay out of pocket costs around three times what they paid as employees,” adds Mastrogiovanni.

The white paper quantifies the retirement health care costs saving gap between what has been saved using an IRR and what will be needed to cover projected health care costs. It shows that a healthy 45-year-old male earning $50,000 and planning to retire at age 65 using an 80% IRR will face a shortfall of $127,299 in retirement health care costs.

This individual would be able to close this gap with additional annual contributions of $3,460 a year, or with a 50% company 401(k) match, an additional $90 per two week pay period. For a 55-year-old, eliminating the savings gap requires a $25,679 lump-sum investment or an annual additional contribution of $3,291 or $84 a pay period.

“Modest additional contributions to 401(k) plans, HSAs, Roths, annuities, or other products such as life insurance can help close this gap to reduce, or possibly even eliminate, the impact of unexpected health care costs in retirement,” says Mastrogiovanni.

The paper is available here.