Using Preferred Stocks To Keep Pace With Healthcare Costs

Everyone contemplating retirement (current or future) is wondering about the same thing – how to cover what we can all agree are out-of-control and ever-increasing healthcare costs.

To help answer that question, Fidelity, in a somewhat self-serving report that they release every year, attempts to estimate the average nest egg needed to cover future estimated out-of-pocket costs (not including long-term care costs, if any). As it turns out, this annual Fidelity report has become an important benchmark for employers as many base their annual employee health benefit program on the report’s findings.

In 2002, for example, the Fidelity report estimated that a retiring couple would need an average of $160,000 to pay for healthcare costs in retirement. In 2009 that number had grown to $240,000.

On Fidelity’s website their retirement calculators assume an annual 6% increase in such costs, on average. That’s way beyond the overall inflation rate. And a major thing missing from the Fidelity analysis is that it assumes that healthcare providers continue to provide the same coverage for that additional 6%. More commonly, we hear that the extra cost each year provides less coverage.

Note that averages can be misleading since, in this context, it means that half of us will need more and half of us will need less and none of us knows, sitting here today, which half we’re going to be in when the time comes (although many of us will be thankful just to be in any half).

Starting with Fidelity’s $160,000 in 2002, this chart shows the estimated average nest egg needed by the end of 2010.

This chart syncs up pretty close with the $250,000 estimate from Fidelity’s 2010 report as well.

This all leads to a couple of other questions, of course. One being how many of us have an extra quarter-million laying around that we can set aside just to deal with anticipated healthcare costs. With the answer to that question being about 30%, we all know that the healthcare debate in Washington is long from over, irrespective of the 2010 solution that few seem to be happy with.

But an equally compelling question is, regardless of the size of your nest egg, how can you keep up with Fidelity’s 6% annual increase estimate so that we can at least feel like we’re not getting any further behind? How can the nest egg be invested such that it consistently produces an annual return of at least 6%?

The alternatives that provide a fixed known return, in order of risk (lowest to highest) mostly come down to: U.S. Treasuries, bank Certificates of Deposit (CDs), corporate bonds and preferred stocks (or mutual funds/ETFs that are based on such securities). Because there is a high degree of liquidity required here in case of a real emergency we can eliminate other less-liquid alternatives (i.e. real estate is probably out) or those with higher risk and/or highly inconsistent, unknown returns (common stocks, currency trading and commodity futures).

One way to help mitigate some risk associated with preferred stocks is to throw out all but the highest quality issues. For example, just consider fixed-dividend preferred stocks that are (1) rated investment grade, (2) have ‘cumulative’ dividends so that if the issuing company skips a dividend payment they still owe you the money and (3) are issued by a company with a perfect track record of never having missed a preferred stock dividend payment.

This chart compares these alternatives to Fidelity’s 6% annual requirement estimate, starting in 2002.

Depending on the number of older issues reaching their maturity dates and new issues being introduced, there are between 1,000 and 2,000 preferred stocks trading every day. Not all are created equal. In fact, the highest quality issues as described here represent the top 10%.

Bank CDs and Treasury Notes are never going to get it done and Aaa-rated corporate bonds consistently fall short of the 6% mark as well.

But for those eyeing Fidelity’s 6% annual target, the highest quality preferred stocks may allow investors to at least keep pace with the ever-increasing cost of healthcare.

Many Happy Returns.