Preparing for Rising Medical Costs in Retirement - 2016 April 8, 2016 by Andrew Friedman, Jeff Bush of Eaton Vance SUMMARY The Affordable Care Act (commonly known as the ACA or Obamacare ) has had a significant effect on retiree health care costs and retirement planning, and those effects are likely only to increase in the years ahead. People nearing or in retirement need to understand the extent to which their medical expenses are likely to increase, and steps they can take now to help ensure they will be able to afford medical care after they retire. The ACA is not a new government-run health plan. Instead, it is an effort to ensure that virtually every American has health insurance. The law includes only very modest efforts to reign in the cost of medical care; its purpose is simply to make sure that Americans have insurance coverage to help them meet those costs. Is the ACA here to stay? We believe that a full legislative repeal of the ACA is unlikely, even if the Republicans claim the White House and hold both houses of Congress in 2016. By that point, tens of millions of low- and middleincome Americans will be receiving federal subsidies, allowing them to have health insurance for the first time. It will be difficult to repeal that help when it becomes so widespread. Although the law likely will remain in effect, Congressional Republicans have taken steps to reduce its funding. The 2015 government appropriations legislation delayed the implementation of three taxes intended to pay for ACA outlays: The Cadillac tax (40%) imposed on high cost employer health plans is delayed until 2020; thereafter tax becomes deductible. The medical device tax is delayed until 2018. The annual fee on health insurance provider premiums written ( belly button tax ) is delayed until 2018. In addition, the legislation reduced an important source of revenue for insurance carriers. The ACA requires carriers to provide insurance to people with pre-existing illnesses on the same basis and at the same price as insurance provided to healthy applicants. To encourage insurers to undertake this Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
additional risk, the law provided for government reimbursement of significant losses that they incur as a result of this requirement. (Republicans have referred to this provision as the ACA bailout.) Conversely, the law requires insurance companies that earn a significant profit to turn over some of the profit to the government to help defray the cost of loss reimbursements paid to other carriers. Under the law as enacted, if loss reimbursements exceed profit contributions (as has turned out to be the case), the government would make up the difference from generally available funds. Late in 2014, Congress, at the behest of the Republicans, passed a law requiring the loss reimbursement account that year to be budget neutral. This change precluded the Administration from shifting funds from another budget item to reimburse loss companies. Because losses far exceeded profits, the change permitted reimbursement of only 13% of the $2.9 billion in reimbursable losses for 2014. The 2015 appropriations legislation extended this requirement of revenue neutrality for an additional two years, at which time the reimbursement program ends. Faced with losses that will not be recouped, companies are considering exiting the ACA program. Those remaining are likely to increase premiums and reduce policy benefits to curtail their losses, increasing policyholder outlays significantly in the process. Carriers also might increase non-aca and retiree medical insurance premiums and reduce benefits to recoup revenue lost due to the ACA reimbursement change. Effect on retirees The ACA as well as the operation of the health care sector generally is likely to affect the costs of medical outlays in retirement in a number of ways. The most significant of these are discussed below. 1. Imposition of a new 3.8% tax on investment income To defray the cost to the government of new premium subsidies for lower- and middle-income Americans, the ACA imposes an additional 3.8% tax on investment income to the extent it is received by families with income in excess of $250,000. This new tax, combined with a separate tax rate increase included in legislation to avoid the fiscal cliff, caused the top tax rates on investment income to jump 10 percentage points in 2013. According to the non-partisan Congressional Budget Office, tax rates imposed on high-income taxpayers are now the highest they have been in the past 35 years. (Congressional Budget Office Report, November 2014). Due to this significant increase in tax rates, investors who rely on investments to fund their retirement are finding that their after-tax income is not as high as they expected. 2. Reduction in Medicare reimbursement rates, which may dissuade doctors from seeing Medicare patients The 3.8% tax covers about half of the expected outlays under the ACA. The remaining outlays are covered by a reduction in the reimbursement rates paid to doctors who see Medicare patients. This reduction in reimbursements has led a number of doctors to stop seeing Medicare patients altogether. As a result, retirees who want medical care from a particular doctor might find themselves having to pay for the treatment and then recover what they can under Medicare. 3. Shifting of costs to insureds Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
As discussed above, policyholders are likely to face higher premiums and reduced policy benefits as insurance companies remaining in the program seek to reduce losses associated with coverage of insureds with pre-existing illness conditions. Already policies offered through the program are incorporating higher deductibles and additional cost-sharing requirements. This trend is likely to accelerate in coming years. These changes to conventional insurance arrangements are likely a precursor to similar changes to the arrangements upon which retirees rely. As discussed in the next section, Medicare reimbursement restrictions and supplemental insurance policy changes similarly are likely to shift additional costs to retirees. 4. Move toward outcome-based medicine As the baby boomers age, the cost to the government of Medicare coverage is going to outstrip the associated revenue the government receives. It is reasonable to expect Congress, at some point, to enact legislation that curtails procedures and treatments eligible for Medicare reimbursement under the precept of outcome-based medicine, particularly near the end of life when the sustainable benefits of the procedures are less certain. The costs of those procedures thus will be shifted to the individual. 5. No national plan for long-term care coverage As life expectancies increase, the need for and cost of end-of-life medical care also increases. As finally implemented, the ACA does not enhance the availability of long-term care insurance. As the baby boomers age, the availability of that insurance is likely to decline, and the cost of the policies is likely to increase. Planning to defray medical costs in retirement A retiree should plan on three types of medical expenses in retirement: Health insurance premiums, including Medicare coverage premiums, prescription drug coverage premiums, and a supplemental insurance policy to fill in Medicare coverage gaps. Out-of-pocket costs, including deductibles, co-payments, and payment for treatments not covered by insurance. Long-term care policy premiums. The above trends make clear that these medical costs are not going to decrease, and that preparing to pay them during retirement is crucial. Investors approaching retirement should work with financial advisors to reduce the tax drag on their investment income. Some investments such as municipal bonds, master limited partnerships, and real estate investment trusts are more tax efficient because they shield some or all of their distributed investment income from federal income tax. The tax savings enhances the after-tax returns these investments provide. Other investments are less tax efficient. Some mutual fund managers take taxes into account in deciding the trades their funds should make, but other managers seek high returns regardless of tax consequences. The latter strategy can result in frequent trading, short-term gains distributions taxed at ordinary income rates, and December surprises where large dividends are declared late in the year when it is too late to take action to offset the adverse tax consequences. If a manager does not take taxes into account, an investor can lose almost half of the annual returns to taxes.1 To avoid this result, investors should consider holding tax-inefficient investments in tax-deferral Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
vehicles. As a starting point, investors should make sure to maximize contributions to tax-qualified IRA and 401(k) accounts. After maxing retirement plan contributions, high-income taxpayers can obtain additional tax-deferred compounding on retirement savings by holding a portion of their non-qualified assets in an annuity. Annuities function much like an IRA, except that the initial investment itself is not tax-deductible. The owner of an annuity invests assets in a choice of investment options. Earnings on those assets accumulate tax-deferred. When withdrawn from the annuity, earnings are taxed at ordinary rates (and if taken prior to age 59-1/2 may incur a tax penalty). In a rising tax environment, the tax deferral feature of annuities becomes increasingly valuable. An annuity also can operate as a source of funds to defray annual medical expenses (not unlike the need to defray a fixed mortgage during early years of working). If the investor adds a living benefit rider, the annuity will provide an annual income stream that will continue regardless of how long the investor lives. The annuity payments can be used to defray annual medical expenses. Many of the medical costs in retirement are fixed: long-term care premiums, supplemental medical insurance premiums, the cost of doctor visits for annual checkups, etc. An annuity can ensure that the retiree has annual income to help defray these expenses. One should factor into their planning the very real effect of inflation. Close consultation with a financial professional will aid in identifying a realistic inflation-adjusted number. For instance, suppose an investor determines that the total of his Medicare insurance premiums, the deductibles and co-pays on the insurance policy, and long-term care premiums is $,1000 per month. He can purchase an annuity (deferred annuity if he is still working; immediate annuity if he is retired) that provides an annual payment of $12,000 for the remainder of his life (or, if he wishes, for the remainder of his and his wife s combined lives). By doing so, the investor need not be as concerned about defraying medical costs during retirement. For more information, please read the disclosure below. Disclosure All annuity guarantees are subject to the claims-paying ability of the issuing insurance company. Federal income tax laws are complex and subject to change. Annuities contain fees and expenses such as mortality and expense (M&E), rider charges, investment management, surrender charges and administrative fees which will lower returns. Additionally fixed annuities may embed their costs in the interest rate or income payment amount. IRA fees may include brokerage commissions and service fees and fees for opening, maintaining and closing accounts. An IRA is an investing tool used by individuals to earn and earmark funds for retirement savings. There are several types of IRAs: Traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
Traditional and Roth IRAs are established by individual taxpayers, who are allowed to contribute 100% of compensation (self-employment income for sole proprietors and partners) up to a set maximum dollar amount. Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer s income, tax filing status and coverage by an employer-sponsored retirement plan. Roth IRA contributions are not tax-deductible. SEPs and SIMPLEs are retirement plans established by employers. Individual participant contributions are made to SEP IRAs and SIMPLE IRAs. A fixed annuity is an insurance contract in which the insurance company makes fixed dollar payments to the annuitant for the term of the contract, usually until the annuitant dies. The insurance company guarantees both earnings and principal. A deferred annuity is an annuity contract that delays payments of income, installments or a lump sum until the investor elects to receive them. This type of annuity has two main phases, the savings phase in which you invest money into the account, and the income phase in which the plan is converted into an annuity and payments are received. If investors withdraw from an annuity prior to age 59 ½, a 10% tax penalty on the earnings is imposed. Withdrawals will reduce the contract s value and death benefit. Within a life insurance policy, if the cumulative premium payments exceed certain amounts specified under the Internal Revenue Code, the life insurance policy will become a Modified Endowment Contract (MEC). Taxation under a MEC is similar to taxation under an annuity. Under a MEC, the death benefit payable to the beneficiary is not subject to income tax. Pre-death distributions are taxable to the extent of gain in the policy and are subject to a 10% tax for policy owners under 59 ½ years of age. Annuities may be comprised of a wide range of individual investment subaccounts. Each subaccount has its own investment goal and style (and, as a result, its own level of risk). Some of the subaccounts offer the potential for higher returns with higher risk, while others seek stable returns with relatively less risk. There is no assurance any of the portfolio s objectives will be achieved. About Risk An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer s ability to make principal and interest payments. Because the Fund may invest significantly in a particular sector, the Fund share value may fluctuate more than a fund with less exposure to such sector. Investments rated below investment grade (typically referred to as junk ) are generally subject to greater price volatility and illiquidity than higher-rated investments. Derivative instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk. If a counterparty is unable to honor its commitments, the value of Fund shares may decline and/or the Fund could experience delays Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.
in the return of collateral or other assets held by the counterparty. No Fund is a complete investment program and you may lose money investing in a Fund. The Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description. About Eaton Vance Eaton Vance is a leading global asset manager whose history dates to 1924. With offices in North America, Europe, Asia and Australia, Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company s long record of providing exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today s most discerning investors. For more information about Eaton Vance, visit eatonvance.com. Andrew H. Friedman is the principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He and his colleague Jeff Bush speak regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. They may be reached at www.thewashingtonupdate.com. The authors of this paper are not providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement. Copyright Andrew H. Friedman 2016. Reprinted by permission. All rights reserved. The views expressed are those of Andrew Friedman, Jeff Bush and Eaton Vance and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. Eaton Vance does not provide legal or tax advice. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Individuals should consult their own legal and tax counsel as to matters discussed. Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing. 2016 Eaton Vance Distributors, Inc. Member FINRA/SIPC Two International Place, Boston, MA Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.
02110 800.836.2414 eatonvance.com Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.