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Jason Stipp: Welcome back. I'm Jason Stipp, site editor for Morningstar.com, and welcome to the third panel in our Individual Investor Conference, "Get a Handle on Health-Care Costs."

Medical expenses can be one of the biggest unknown for retirees, with some estimates showing that you could spend up to $200,000 out-of-pocket in retirement for health-care costs.

So, how can we plan for such a big question mark?

I'm joined today by two great panelists to help us get our arms around this issue. We have Dr. Carolyn McClanahan. Dr. McClanahan is founder of Life Planning Partners and a member of the National Association of Personal Financial Advisors, the Financial Planning Association, and the American Academy of Family Physicians. Financial Planning Magazine named her as a Mover & Shaker in the Financial Planning Profession for her work on insurance issues, and the National Association of Personal Financial Advisors named Carolyn one of the 30 most influential people in the financial planning profession.

Carolyn, thanks for joining us today.

Carolyn McClanahan: Thanks you for having me.

Stipp: And Mark Miller is a columnist and regular Morningstar.com contributor, who writes about trends in retirement, aging, and the economy. He's the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living, writes a syndicated column for Reuters, and blogs about retirement planning and saving strategies at RetirementRevised.com.

Mark, thanks for being here.

Mark Miller: Thank you, Jason.

Stipp: Let's start off with that number I mentioned at the top, $200,000. That was an estimate from Fidelity of out-of-pocket health-care costs. So, this is not all your health-care costs that might be covered by Medicare and other things. This is an out-of-pocket cost you might expect to spend in retirement. It sounds like a big figure; it's also an average price. So, Carolyn talk to me a little bit about that figure, where it's coming from and how people should think about it.

McClanahan: Well, Fidelity does this number year-to-year, and actually it's $220,000 for this year. It came down from $240,000 the year before. So that shows there has been a trend downward in health-care spending. Is that going to stick?

The problem with this number is it is an average. It does not count long-term care costs. It does not count your out-of-pocket drug costs for over-the-counter drugs. So, a lot of variables there.

But the most important thing people need to understand is because it is an average, who is really average? You think about it, and if you're a health-care consumer or if you're very unhealthy, your number might be much higher than that. Likewise if you rarely go to the doctor, they have to drag you in by the ambulance, then your health-care costs may be significantly lower.

Miller: The decrease in the number is interesting, and that forecast that they do every year at Fidelity is very much tied to Medicare trends. So, of late, it's been impacted downward in a good way by moderation in prescription-drug costs. The Affordable Care Act actually also has some cost-cutting initiatives that affect Medicare, which maybe we'll talk about later. And then the third thing that's interesting is that the Medicare population is getting younger. As boomers start to age into the post-65, the bulge is still at the young end, comparatively, for Medicare. So, they're healthier, generally.

So, those are some of the things that are driving that Fidelity number.

Stipp: Carolyn, $200,000 is a lot of money. Some folks will look at their retirement portfolio, and it might be around $200,000 in total, and they're hoping that's going to cover all of retirement.

This is a big question mark, and I think you're uniquely positioned to talk about this issue having been a physician and also financial planner. This is a big unknown, as you mentioned: my health. How do I start to figure out if am I going to need a lot more than $200,000? Am I going to need a lot less than $200,000? Nobody knows for sure, but where do you start?

McClanahan: Well, the argument that I have is we need to quit thinking of retiring at 65. We all know that was the retirement age came with Social Security back in 1934, and they picked 65 back then. If you retired at 65, you had half a chance of making it to 72. Now you're living 30 and 40 years in retirement, so people should really think about retiring early--I mean not retiring early, making sure they are maintaining their safest asset, which is their human capital.

Stipp: Which is the income that they make from continuing to work?

McClanahan: Right, their ability to work. And if you're really healthy, then you should work longer, because you don't know what's going to happen in the next 30 or 40 years.

Stipp: So, it's a way to kind of cut off some of that risk, because you're making more money upfront.

Mark with the $200,000 estimate, what kind of people in your experience are spending a lot more than that? What kind might be spending a lot less than that? Where is the variance coming from?

Miller: Well, oddly, longevity is an important factor in a way that you might not think. So, people who are sicker, tend to live less long, their lifetime spending will be less. You wouldn't call that good news, but that is a key factor.

Regional differences can be huge. So Medicare smoothes out a lot of this, because the rates and the premiums are the same nationally. But, for example, Medigap policies, which are supplemental policies that are used by people using traditional fee-for-service Medicare, the prices of those policies can vary a lot around the country.

And then you have some underlying trends in the cost of health care. So, for example, we are not talking yet about long-term care, but nursing home care is a good example where the cost of that can vary tremendously around the country. For example, New York is, I think, the highest-cost region in the country; whereas, certain other parts of the country--I know some parts of the south, for example--have very low costs.

And if you want to know about that, there is a great survey that's sponsored every year by a company called Genworth, which is one of the main sellers of long-term care, and they have a company called CareScout. They do actually an in-depth look, where you can click through an interactive map and get a look at the annual costs of different types of care in different parts of the country, and you can see huge variation.

Stipp: We are going to certainly circle back and talk about long-term care in more detail. Carolyn, you have spoken about--and written about as well--your attitude toward health care as a health-care consumer being something that you should think about as far as how much you plan for health-care in retirement. Can you talk about that a little bit?

McClanahan: To me, consumers are the biggest determinants of how much they're going to spend in health care, because two things you can do is you can make certain you're maintaining a healthy lifestyle, but the most important thing that people don't talk about is what's your attitude towards health care usage? You have some people who go to the doctor for everything from an itchy rear hand to a hangnail, and those people will use a lot of health-care dollars. So, if you know if you like to go to the doctor a lot, every time you're worried about something, you need to save more.

Likewise, I had a patient once who was 98 years old, and she said to me, I haven't been to the doctor in decades. And I asked, why are you coming now? She says my toenail is too thick to cut and I need you to use those industrial toenail clippers you guys have. That women, she is probably in the less than 10th percentile if you look in the Fidelity numbers or the EBRI numbers on health-care costs. So, know your health-care utilization pattern and plan for that.

Stipp: And this is an interesting question we got from a reader about asset allocation decisions. And readers are thinking, well, one of my big expenses might be for health care. So when I'm thinking about how I translate that back to a portfolio, does that have any direct impact on the way I might allocate my assets? So, if I expect to need a lot of money in health care, would that change my asset allocation?

McClanahan: For us and our clients, it does not, because to me, the fixed-income portion of your portfolio, that is your safety net. That's basically the money you can't lose. So you do have to calculate your health-care costs in that, and it needs to be part of your overall thing, because it's just as important to be able to eat and keep a roof over your head as it is to pay for your health-care costs.

So, overall, I think the portfolio allocation decision should be based on how much money do you have that you can take risk with.

Miller: I think about this mainly is an insurance question, but in the broadest possible meaning of the term insurance. Meaning, I would start with social insurance--Social Security. Anything you can do to delay filing, which boosts your lifetime income from Social Security, could be very, very important. As I mentioned before, Medicare smoothes out a lot of health-care costs, not all of it, but another variation can be, for example, what is your income after age 65? Because as a lot of our listeners know, there are these high-income surcharges on Medicare that kick in over certain income levels. So there is some interesting questions around managing all of those dimensions to this.

McClanahan: And that brings me to the point of …you talked about collecting Social Security as late as possible. It's important to understand your health lifestyle. I am a big proponent of using the website, Living To 100. I have no relationship with them at all, but it really looks at what's your lifestyle and how does that affect your longevity? If you are a 350-pound diabetic, age 62, and you're smoking, you probably should claim Social Security at age 62, and not wait to 70.

Miller: Yes, although there is also a spousal question there. So people need to think about this as couples. But that's a whole other topic…

Stipp: But the point what are you saying here is although health care can be an unknown in some respects, there are certain things you can control: when you take Social Security, which could provide you for more income later when you might need income for health care…

Miller: It's, how do you control against risk? For example, another thing one can have in their back pocket as a possible, I would say, last choice, but certainly an option, is a reverse mortgage.

There are ways to go if you find yourself with a large, unexpected expense. Long-term care insurance we can get to, but that's another possible strategy.

Stipp: And one of the things you had mentioned earlier about health-care costs and the variance there is location, and Mark you had written an article for Morningstar.com that dug into this issue, and it is surprising the variance that you see just from state to state.

Miller: A lot of it is hospital costs. So in a sense, when you think about retirees on Medicare, the relevance of that diminishes, frankly, because Part A of Medicare covers what it covers. So from an out-of-pocket standpoint, no. But when you look at certainly copays, and if you look at people who are retired who are younger than 65, this could be an issue. But there are huge variances in what hospitals charge for apples-to-apples services, not only from region to region, even in a region.

A lot of this reflects--and I'd be interested in your view on this Carolyn--but to me, from my reporting, a lot of its reputational. So, if you're in a big city like Chicago, we've got two or three hospital systems that are reputationally known as the top. And they've been able to get away with charging high prices for things because of that market power.

One of the things I think we're going to see as a result of the Affordable Care Act is people paying more attention to these differences when they go into the public exchanges to shop for policies, and see that policy A costs less than policy B, because policy B is with a network of these high-reputation facilities. But it's more hospitals, I believe, than it is physicians. What is your take on that?

McClanahan: Well, again, its regional variation. In Jacksonville, Fla., where I'm from, we have Mayo Clinic and the University of Florida, but our long-term care costs there in Jacksonville are $60,000 to $70,000 a year as opposed to…

Miller: $90,000 in New York.

McClanahan: No, $120,000 in New York. New York is way more expensive. So, you can have great places that are still keeping the costs relatively low. So, I think hospitals matter and location matters, too. It's just more expensive to live in the Northeast than it is in the Southeast.

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Stipp: When I think about some of the differences in the health-care cost for the same service, part of it is just, are we as informed and educated as consumers as we should be? So, I don't know what the cost of a certain test is.

Miller: Or what it should be.

Stipp: So, I don't if this hospital is charging me a lot more or not. So, is there an element of the ability for me to be a better educated health-care consumer, where I can actually begin to make choices, which is how a free market should work?

McClanahan: That's a whole mess. Because a fee-for-service system--you got to the hospital now, you get unbundled bill. First off, you don't know whether you received that care. The mistakes in hospital bills are huge. So, I think it's a mistake for people to think that they can actually be a more savvy consumer when it comes down to the nuts and bolts of it.

As far as long-term care and retirement costs, though, they can be a more savvy consumer in how they choose to utilize the health-care system, which we already talked about.

One of the things that we talk about in our practice is not about long-term care insurance or funding how you're going to pay for this, but creating an overall long-term care plan. You need to understand what are your family resources? If you have a large family, people can kick in and help you some. Aging in place. Now with technology, you can put cameras in your parent's homes, so you can watch them more easily. You can actually hook little devices to their pillboxes to make certain they're taking their medications. So, there are lot of things that we can do on a personal side to help control costs to reduce needing to go into the health-care system to get the care you need.

Miller: I think the long-term care thing is really a wildcard. A lot of people have heard this statistic that three quarters of us will need some kind of long-term care in our lives, but that's a misleading statistic, because that includes everything, down to people who are just at home with a family member helping them out with things.

The best data I've seen on actual, hardcore nursing home expenses, where the numbers start really getting high, is 25% might need something for a year. And the numbers go way down from there: 5% might need three years. So, it's truly a wildcard in the deck here. It's not going to affect everybody, hardly. But those who do get hit by it, it's a very big expense.

Stipp: So, I think that's a great point. Because I think one of the things that people potentially worry about is, what if I need long-term care for many, many, many years, and it's very expensive per year. First of all, what are some of the average costs that you might spend in a nursing home, and secondly, what are the odds that I might need many years of long-term care? Is that a big population that ends up in nursing home…

McClanahan: Well, it is. One of the problems with living a healthy lifestyle and taking great care of yourself is, are you going to be at higher risk for things like dementia? Dementia is where long-term care costs are rising and the need is much more intense.

You can go 14-15 years: Are you going to be that outlier? That's where I talk about, it's very, very important for people to have great advance directive planning. The problem you get into with families is, nobody wants to talk about the end-of-life situation. When you have a person with dementia, once they've lost their capacity to plan, it's too late to plan.

So, making certain you're doing advance directives early-on that say, if I have dementia, don't put feeding tubes in me. If I have dementia, if I get a serious infection, don't treat it, let me die, because I don't want to live that long with dementia.

Miller: The median cost in 2012 for a private room was a little over $80,000, and it's rising at about 4% to 5% a year.

Stipp: Which is more than the inflation rate that we've been seeing, but not as high as some of the other inflation that we've been seeing.

McClanahan: Right.

Stipp: We actually had a reader question about this: that $200,000 figure that Fidelity cites, does that include any long-term care in there?

Miller: No.

McClanahan: Not at all.

Stipp: That would be above and beyond your out-of-pocket expenses…

Miller: It's premiums, it's copays, it's out-of-pocket. Like I said before, It's very much driven by Medicare; that's a retirement number.

McClanahan: Yes.

Stipp: And since we're talking about long-term care. We're starting to get a lot of questions about long-term care insurance. I think this is a tool that people see where they can manage some of that risk, but I think there is also potentially some complexity. People don't know when, people don't know what to look for. And there are also changes in the industry as well.

So, let's kind of take them piece by piece. When you're thinking first of all about long-term care insurance, who is it good for? Who should consider these types of policies? Is it everybody?

McClanahan: It's really tough. Because the traditional long-term care market right now, the policies are very, very expensive. So, you're getting to the point where the people who can afford the policies are the people who can almost afford to self-insure.

So, in the – 15 years I've been in financial planning now, it's changed dramatically. Right now the only policies that look decent to me, as far as a protection standpoint and not losing your short to pay for them, are more the hybrid type policies, and those really aren't that great. It's like putting your money in a savings account that's dedicated toward long-term care.

Miller: You have to plough in quite a bit of cash upfront.

McClanahan: Right.

Stipp: So, is one of the reasons long-term care so expensive is because of that adverse selection that we hear about, where the only people who are buying long-term care insurance are the ones that need it, and so that's why it's so costly?

McClanahan: Well, I think what's happening is, early on, the insurers didn't realize how much people would love their policies. They always plan on people letting a certain number of the policies lapse, and that's not happening, because people are afraid of the long-term care cost.

So, a couple of years ago, or last year it was, one of the major insurers, Hancock, had to do a major increase in the premiums because they realized they were facing a huge amount of claims going forward, and the people they thought would drop-off didn't do that.

Miller: Several of the big carriers have been pushing through big increases, so is Genworth. The lapse rates have been an issue.

Lately, a big issue has been the low interest rate environment, which makes it tougher for the insurers to earn a return on their bond portfolios, which is a substantial part of how they fund the payouts on policies.

But there was also in the early days a lot of mispricing for reasons Carolyn was touching on.

It's really, I refer to it as kind of a dysfunctional market. Commercial long-term care insurance policy are reaching, maybe 5% of the total potential market; it's a niche market. One thing that a lot of people don't know is that the insurers are fine with that. They're not looking to write a lot of additional business and grow it, because of all the risk and capital requirements associated with it.

Stipp: It seems like their experience has been, it's hard to profitably write some of the policies, if a lot of them are getting out.

Miller: Some have been getting out--actually a number of them have been getting out. So, it's a troubled market, is the headline.

Stipp: So I guess if the market is troubled, if it looks like it's expensive, and the only people that can maybe afford it would be people that could also potentially think about self-insuring, is this something that you would typically recommend to your clients? Or is there a specific kind of client that should really take a close look at this?

McClanahan: Well, the main reason that we would recommend long-term care insurance in today's environment--we used to recommend it to anybody who could afford it in the past--but in today's environment, it's to segregate a bucket of money for the long-term care.

If families see that there's money there to take care of their parent, they're more likely to use it. We've had situations where there is money that can be spent on care for their loved one, but the family argues, because it's going to decrease their inheritance. You hate that that happens, but it does. And so if you have a bucket segregated, that says, hey you can spend a lot more of this for long-term care costs, it keeps down family angst and fights over how they're going to take care of their family member.

Miller: I'd be interested in your take on this: Actuaries who I have talked to about this self-insure question, as a rule of thumb, have said to me that you need to be able to identify roughly three quarters of a million dollars in assets that could be devoted to long-term care in a worst-case scenario. I don't know if that number sounds right to you.

McClanahan: Well, again, that's a potential outlay, for sure, especially with dementia.

Miller: That's a "safe" assumption.

McClanahan: Right, right. Again, that's why we need to have conversations in this country about advance directive planning. Making certain that if you don't have the money set aside, are you willing to decimate your spouse's ability to function if they live a lot longer than you do? Or do you want to decrease the inheritance for your family?

Miller: Another point on the planning side of this is, if you're working with a financial planner, one thing you can do is test the plan against a couple of scenarios: What if I or my spouse need two years of care? You can just say to the plan, take out five years total at $80,000 a year, starting at this age, and see what it does to your plan. What does it do to your odds of success? The success rates are usually defined as, does the money last to age 95, or whatever. But you can just run these numbers for more affluent households and see how they look.

Stipp: Then look at it and say, what would that mean for the rest of everything else that I need to meet, and how comfortable am I if this could happen?

McClanahan: Well, and that to me brings back the argument, are we making people over-plan and over-save? And as a former emergency room physician, where people come in and you see them die very prematurely, it makes you feel really bad if you made people save an extra three quarters of a million dollars, and they didn't get to enjoy their life while they're younger and healthy. So, to me that's why planning is a year-to-year process, and you have to really be clear with yourself about what you would want once you become incapacitated.

Miller: Right. I do think that the reverse mortgage is another interesting option. Now I'm not pushing reverses, I'm not a huge, huge fan of them. They're kind of expensive and there are issues around them with security of maintaining ownership of your home. But, again, it's something to think of as a cushion that's available to you in the event of a large unforeseen need.

Stipp: A lot of viewers are interested in long-term care insurance, as far as specifically if I'm comparing policies, what are some of the big differences between some of the plans that might be out there? Are there any things that should be red flags or warning signs? You also mentioned hybrid policies. Can you just do a quick rundown of what people might see as they start to go out and look at these?

McClanahan: Well, with a hybrid policy, its hybrid life insurance and long-term care. One of the problems and the stumbling blocks for people buying long-term care insurance is they hate putting all this money into something they may not use. That's any insurance. And ideally you don't want to use it, but you can't count on what I call the drop-dead plan, because if you drop-dead you're not going to use your long-term care insurance.

So with hybrid policies, people like those a little more, because if you die, your family gets a death benefit. If you need long-term care, you get a long-term care benefit. But if you really run the numbers, it depends on when you make the claims on the policy. You're doing anywhere from as well as putting it in a money market interest account versus maybe having the equivalent of a good bond fund; that's it.

Miller: So there could be inflation erosion issues there.

McClanahan: Right, Right.

Miller: I'll just mention one other thing about going under-the-hood on standard LTC policies and ways to affect the price. One that's important is how much inflation protection you build in. There are a couple of different ways to buy inflation protection--some more expensive than others.

Another is what elimination period you choose. In other words, how many days you pay for before the plan kicks in. And the last one is how many years of protection.

So one way to buy these things at a little more modest price is to buy some protection. A lot of the early plans were kind of Cadillac level, just insured to the max against everything. But some protection could be better than none. So there are ways to buy policies that might be more of a Chevy than a Cadillac.

Stipp: What about the timing of when you would start to buy long-term care insurance? How does that play into the decision?

McClanahan: Well, one is your current health. You always risk becoming uninsurable, that's the problem, and you don't know when that's going to happen. With people who live unhealthy lifestyles--so if you're overweight, if you already have a minor health problem, say high blood pressure or very early diabetes--then you need to get insured. I don't care whether your 30 or 40. If you live a totally healthy lifestyle, you're still running a risk of something bad happening where you become uninsurable, but most people look at long-term care and insurance once they hit in their 50s.

Stipp: If you wait longer does just your advancing age become an issue at all in your insurability?

McClanahan: Well, two things: The policies become much more expensive, and again, the older you get, the chance you're going to have a problem that makes you uninsurable becomes higher.

Miller: Because you have a pre-existing, although, the expense is relative because you've got more years of paying. But, yes, I think the pre-existing is a bigger concern.

Stipp: Just to be clear: We had a reader asking what kind of long-term care insurance comes with Medicare.

McClanahan: None.

Stipp: There's none.

Miller: Well, except one exception. Medicare pays for the first 100 days of a skilled nursing facility after you've been admitted to the hospital under Medicare.

And this is worth spending just a second on. There has been a big fracas going on lately over something called observation status admissions. Let's unpack it briefly. A growing number of hospitals, will … you go into the hospital, you're sick, you're in for days, you think you're in the hospital. It turns out you've been admitted under what's called "observation status." We won't go into the detail of why hospitals are doing that; it's complicated. But it means that you're not formally admitted, and therefore not eligible for this 100 days of care. So let's say then you're sent to a rehab facility and suddenly find out that you were under this observation status and all of a sudden ineligible.

So, A) that's what Medicare will pay for, and B) something to watch out for. There are some initiatives going on to fix that problem right now, including legislation that's been introduced in Congress. I think it's kind of an unintended consequence of some Medicare policies, but I think everybody agrees it needs to be fixed, but it's an issue right now. It's really unfortunate because when you're going to the hospital, the last thing you want to be thinking about is the red tape of how you were admitted under Part A Medicare. But it's something people should be keeping an eye on.

Stipp: We've mentioned before, and touched on, self-insuring. So if a plan would call for that to be a course of action, how does that translate to a portfolio plan. Does it mean that you have to hold certain assets if you're going to self-insure? Because health care can be so unexpected, it doesn't seem like you could hold a lot of long-term assets if you were segregating a piece of your allocation to fund them.

McClanahan: Overall, people who are retired are no longer using their human capital. They should be conservatively invested to begin with. I take argument with people who say that, well, bonds are horrible right now. Well, yes, the yields on bonds are not great, but they're your safety net. So especially with current market valuations, you've got to maintain that safety net.

So I think that, yes, if you're going to self-insure, again it becomes part of your overall portfolio and you need a significant amount in safe assets. Depending on the size of the portfolio … we like to use a lot of individual bonds instead of bond funds--we just feel like it's a better capital preservation maneuver--and you make certain you have them maturing enough each year to give you liquidity in case a long-term care or adverse event happens.

Stipp: So it could be potentially that your allocation to shorter term or safer assets would be a little higher if you are self-insuring and expecting that you would need to be covered more.

McClanahan: Well actually, we base it more on interest rate issues. We stay short-term right now just because of interest rate issues not because we're worried about somebody may need some dollars for health care.

I think studies are coming out now showing that maybe a reverse mortgage earlier is actually a better deal. So let's say that you have a portfolio that's locked up in bonds, and the stock market is not doing so great, so you don't want to sell, maybe that's a good time to go ahead and do a reverse mortgage if you have an acute long-term care need pop up. Then you can satisfy that reverse mortgage as your bonds mature or as the market recovers.

Miller: I think especially if you use the type reverse that acts like a line of credit, rather than the big upfront lump-sum draws.

Stipp: We've been talking about some of the tools that folks might bring to bear as they're managing health-care costs, and we mentioned potentially the ways that you'd claim Social Security. We mentioned reverse mortgages a couple of times. We have some questions about health savings accounts.

First of all, I think we want to clarify what they are. A reader is asking what are the pros and cons and what should I be thinking about if I'm considering how a health savings account would be put to use.

McClanahan: Well, you can only fund health savings accounts before you're 65 and the amount of money you can put in them is very limited. I still love them, though, if you have a high deductible health-care plan, it's money you can put away. You get an instant tax deduction. It gets to grow tax-free forever for health-care expenses. So even after you're 65, you can use it. And yes, it's not a huge amount of money, but it adds up. I started my health savings account when I was in my 30s, and it's quite a bit right now because I just don't use it. So if you don't use it for health-care expenses, you can use it for retirement, you just have to pay taxes on it then.

Miller: They work best for healthy people, because it's dollars set aside to help pay your out-of-pocket expenses. They're always tied to the so-called consumer-directed health insurance plans, meaning high deductible plans in the workplace. So, if you're healthy and don't have a lot of health-care needs, you could accumulate some dollars there, and those plans typically have much lower premiums, on the order of 25% or 30%. Great for young people, in particular, who generally are healthy, and they can set aside that money for something else.

As a way to accumulate big dollars against retirement health needs, I'd say, not so much.

McClanahan: Yeah--I estimated at the rate I'm going, and some of our clients, maybe we'll have one year's worth of long-term care covered through a health savings account.

Miller: I have heard people make the same case about Roths: Use Roths to accumulate dollars for these expenses.

McClanahan: Right. It all adds up. And plus they are protected assets. That's the other thing--especially if you're in a high-risk profession or whatever, health savings accounts, your IRAs, those nobody can take away from you if you're ever attached by a creditor.

Stipp: So with the health savings account, just so we're clear for viewers, if you use the money for a medical expense, it is not taxable, is that correct?

McClanahan: That's correct.

Stipp: OK. And the money that goes in, is that aftertax money or is that pre-tax money?

McClanahan: Well, you get a tax deduction on page 1 of your tax return to put it in. So you put in aftertax money that you've paid income tax on, but then you get to take it off on your tax return.

Stipp: A tax benefit on the front side and….

McClanahan: It's huge … and on the backside.

Stipp: ….and the assets are growing without a tax liability in between.

McClanahan: Right.

Stipp: And provided you do use it for medical expenses…

McClanahan: For health, for medical, right.

Stipp: And a reader was asking, can I use this to pay Medicare Part A and Part B premiums in retirement? Are you allowed to use health savings account?

Miller: I'm not sure.

McClanahan: I don't think you can. We will have to get back on that one.

Miller: I know you have to stop saving in them.

McClanahan: Yes, you have stop saving in them, and I know you cannot use them for health insurance premiums.

Miller: Part A, by the way, you're not paying anything, because that's covered under your payroll tax contributions lifetime. It's really more a Part B, Part D question.

McClanahan: Right.

Stipp: People who are using health savings accounts, they are making investment decisions based on a small set of investments? How should we think about that?

McClanahan: Right. Well, when you start a health savings account, you're only putting few thousand in it each year, it's really hard to do a good diversified portfolio with it. And plus, to me, it's considered part of your emergency fund if you have a big health-care expense. So early on, definitely, we just keep it in the money market accounts within the health savings accounts that we use.

Miller: Fidelity and a couple of other companies that administer a lot of these things have told me that they are very typically invested quite conservatively for that reason.

McClanahan: Right. And if you accumulate a fair amount, I still would keep that overall in a conservative portfolio because you don't know when you're going to have a major health-care expense come up.

Stipp: Right. And if the market should be down and you're in riskier assets that would not be a good time to drawdown that HSA.

Let's talk about some of the other tools that people may consider as they are thinking about health-care planning. Disability insurance, which is normally something that comes along with your job. What are the ways that you would think about that as far as what it's managing and what your liabilities are?

McClanahan: Disability insurance only last until you're about 65 or 67. Some of them are going to normal retirement age, whatever that is for you. To me, they are not a part of planning for health care in retirement. The big thing that people need to be aware of is, if they are doing like I say they should do, and working as long as possible, their disability insurance is going to run out.

So if you are planning on working until you're 75--or I've even had people work until they're 80--you don't have disability insurance then. So you still have to save by normal retirement age for all those expenses that … you're going to still have: your health care, the roof over your head, and food in your belly.

Miller: I'd also mentioned briefly, don't forget about the Social Security disability benefits. The way that works is, if you become disabled before your retirement age, basically your full Social Security retirement benefit kicks in at that point of disability up to the point of your earning credit. I'm not saying you get the same that you'd get at 65 if this happens to you at 50, because you're missing 15 years of credits through retirement. But nonetheless, it's your full retirement benefit that then converts to your retirement benefit at the full retirement age, currently 66. So that's significant.

McClanahan: Well, you have to realize, too, though it's very difficult to get Social Security disability.

Miller: Right. Yes, so it can take more than a year to file and get a claim approved.

Stipp: One thing I just want to touch on briefly is where Medicaid might come in, and I know that it's obviously a terrible situation if you have to have used all of your assets.

Miller: It's something that we hope will not happen to the Morningstar audience.

McClanahan: Right.

Stipp: Conceptually, how does that work, and when would it kick in, and what would need to happen in order for it to kick in?

Miller: For a long-term care need?

Stipp: Right.

Miller: The rules vary by state. Some states now have changed the way they measure your wealth, if you will. But in the main, you have to have spent down almost everything. Generally, it's a couple of thousand dollars left. Some states are now allowing you to still keep your house. I think that's it in summary. You have to spend yourself down to the point of poverty. That's why I say we don't want that happening for the Morningstar audience.

McClanahan: Or anybody. And the thing is, especially with the boomers, how long can our country sustain this spending on long-term care through Medicaid? It's going to be a huge issue.

Miller: Medicaid is paying for half of long-term care. Long-term care to me is the great unanswered policy issue in our health care situation. Medicare isn't perfect, but it covers most stuff pretty well. The long-term care thing is just a mess.

McClanahan: Right.

Stipp: Before we move along, we have a few folks that wanted to talk a little bit about something you mentioned before, Mark: working with financial planner and the value that that can bring as you're planning for health care. I think people wanted a little more detail about that.

I think what you were referring to is the way that you can rerun some tests with some different variables and planners can help you do that. So if you're thinking about using a financial planner, what would you say are some of the benefits of being able to plan and use the software and the expertise they have to make some of these difficult decisions?

Miller: I will answer briefly, because this is really Carolyn's expertise, but I think that the value is, if you're working with the planner, is working with one of these software tools that runs the Monte Carlo simulations out of 30-40 years plus, and says, assuming you work until this age, keep making these contributions to your retirement accounts, crank-in Social Security, you can get a pretty decent idea of how long you can expect your money to last. Then you can just test that for long-term care to say, now crank-in this assumption--give me three years at $80,000 a year of nursing coverage--and what does that do to my long-term plan. But Carolyn could probably address this in much more in detail.

McClanahan: I mean to me, the bigger value of working with financial planners is they can really help you wrap your head around what your needs are, what you're spending. People think the biggest determinant of retirement is how much you've saved. It's really how much you spend, and so if you know how much you need to spend now and in retirement and if you can understand what your health-care needs are going to be by your health-care usage, that can give you a better idea of how you need to plan to save, and …

Miller: And the spending part is just huge.

McClanahan: Right, it's the biggest determinant.

Miller: This is like the old thing where people would say, well, I don't like this outcome when I assume I will get a 5% return on my portfolio. So let me assume 8%; now it looks great. Well, the same can be true on the spending side. I don't like the way my assumption looks if I say I'm maintaining 90% of my pre-retirement spend. Let me take it down to 60%. All of a sudden, things look great. So careful thinking about what you really like to spent--forgetting health care for a minute--is really critical.

McClanahan: Well, you know, Monte Carlo simulation is fun. In reality, though, can you really plan out 30 or 40 years? So that's why I say to people, it's important to maintain resiliency. So, you need to save. You need to really manage what you're spending, and if years are good--and the beauty, to me, of the last 14 years is, we've been through two bad markets and we've been through good markets. So when things are good, that's when you need to put the roof on your house. When things are bad, you see it inherently. People inherently, even if they are wealthy and they have plenty of money, they quit spending as much.

Miller: I agree that the Monte Carlo simulations are far from perfect, but what's neat about them is they do give you a tool for making some decisions. They are just scenarios.

McClanahan: They let you know whether you're just crazy or really crazy.

Miller: Or what if I make a different decision? What if I decide to retire three years earlier? What does that do to my plan? Well, it gives you an idea.

McClanahan: It does. It's a great guide. I totally agree.

Stipp: And it seems like a key takeaway here is revisit your plan.

McClanahan: That's key, yes.

Stipp: As you go along, you'll have more information about your health situation. You will have more information about how the markets did, what the projections look like for your portfolio and you can make adjustments along the way.

McClanahan: Right. The software that's coming out now in financial planning, you can put everything you're doing--all your credit cards, your checking accounts--and it shows you exactly how you're spending money, and it gives you a more realistic picture. The number of people we have come in and say, I spent $3,000 a month, and you find out that what you really spent is $6,000 a month. That's a huge difference in what you need for retirement. It's very telling to really watch what you doing.

Miller: No doubt.

Stipp: So Carolyn, I want to ask you this question specifically because of your history as a physician. My mother before she qualified for Medicare said that she was on the Stay Healthy Plan, which of course, scared the living daylights out of me. But at the same time, I think we would all like to think that we will be on the Stay Healthy Plan and not be sick in retirement. So from a health perspective, the way to manage health-care costs, what are the big things that we can do to, as you've mentioned before, lead that healthier lifestyle where we won't have to potentially spend as much?

McClanahan: You know, the Stay Healthy Plan … as a ER doctor, I saw a number of people in there who retired at 62 because they could get Social Security, but they couldn't get Medicare, and then they had their heart attack shortly thereafter, and $100,000 for a coronary bypass, that will break your retirement plan.

So the number one rule for everybody is, don't count on the Stay Healthy Plan. Always make certain you have health insurance, and there's no reason to go without it now, because with the Affordable Care Act, you can't be turned down. And especially for people in their 60s, the premium tax credits that are available, it depends on your income, could make insurance definitely more affordable than it used to be if you retired early.

So, as far as health--how you take care of your health is very important too. If you have early high blood pressure or diabetes, if you take good care controlling those, you're going to live a normal life expectancy like anybody else. But if you do a bad job taking care of your health, it's going to cost you a lot more money in the long run.

Miller: I'd just underscore the Affordable Care Act, because I think for people younger than 65--in their 50s and so on--this is just huge. You're going to have far fewer people going uncovered. I have even seen some research suggesting that the long-term cost of Medicare will be reduced, because you'll have more healthy people delivered into the Medicare system than we used to due to lack of insurance.

Stipp: Because there is this coverage for those earlier retirement years.

Miller: Yes.

McClanahan: Yes.

Stipp: Mark, you wrote about this on Morningstar.com. I think this is important point to make sure people understand the Affordable Care Act and Medicare. I think people sometimes think that there is overlap there or that you would be using the Affordable Care Act, once you are eligible for Medicare, but that's not the case.

Miller: No, you do not use it. In fact it's prohibited to stay in the ACA exchanges once you're 65. You need to move into regular Medicare.

Stipp: But for folks who are looking to retire at 62, potentially, because they are eligible for Social Security, this would be an area where the Affordable Care Act could manage that gap before you are eligible?

Miller: Yes. And it's also going to help people make decisions about perhaps leaving their jobs earlier so they can go off and work for themselves. People who were just kind of hanging on to jobs but their fingernail just for the health care can now say, hey, I really would like to go off and work part-time, consult, whatever, because I know I can get health insurance.

Stipp: I want to talk about one other big question, Mark that we've alluded to here and there, and that's general longevity and your life expectancy and planning for that, in some ways whether or not you'll actually end up needing a lot of health care. If you do live a longer life, you are going to be spending money on other things even if you stay healthy to the very end. So, how do you help people manage their longevity risk? You hear and you see commercials of people saying, you can live to 100, you can live to 105. Who is the oldest person you know? But on average, how should people think about what their life expectancy might be?

McClanahan: Well, one of the things that you can look at is, if you are 50 and you are healthy, and you're planning on maintaining a healthy lifestyle, you need to start saving more and plan to live longer. Now if you are 60 and you are still healthy, you still have another 40 years. We worry about income planning more when people get in their 80s, and they are still very healthy, and now they are at high risk of Alzheimer's.

So, how to help people wrap their heads around that is, if you are in your 50s and 60s and you are planning on continuing to live a healthy lifestyle, then you might need to continue maintaining your human capital and working. And so, we encourage that highly, and now with the ACA, people can do jobs you love. Even if you bring in $20,000 a year, that's almost like having a portfolio set aside of $500,000. So, think about that.

Stipp: So this could give you an option in your early 60s to continue to work, but you can work less if you don't need that full-time job just for the insurance.

McClanahan: Right. We actually have people now that are in their 40s, 50s, who have these high-stress strung-out jobs that really could hurt their longevity. We have a career therapist we use in our practice--she is not part of our practice; we outsource to her--to help these people figure out what's their next career move, so they are in a job where they are happy, where they can stay healthy, and they can work a lot longer.

Miller: The other thing I think on longevity is--I'd go back to Social Security for a second and any other guaranteed income source. There are a lot of people who still have regular old pensions: people work in the public sector, and maybe a third of those in the private sector. So, make sure you've managed your pension properly, if you have one, to get the most lifetime income.

Then on Social Security, I've written about this for Morningstar: The idea of delayed Social Security filing basically gives you an 8% guaranteed return on what you are going to get annually in income, roughly, for every year you wait up to age 70. Show me another place to get 8% risk-free; I don't think you can.

And even if it means drawing down portfolio assets in the early years of retirement to fund living expenses while you wait, if you have a reasonable expectation of living that long of a life span, it's a great move. It actually improves your long-term portfolio health, because it's removed so much pressure on the portfolio in the out years.

Stipp: We've mentioned this couple of times. We have a lot of reader questions again about early retirement, and we talked about how the ACA could be your insurance in those early retirement years. A reader is asking, just generally about how health should factor in to my decision on early retirement, and it seems like the ACA might change the calculus on that somewhat.

McClanahan: Well the nice thing is, if you want to retire early and you have an uninsurable condition--now nothing is uninsurable. So, that's a beautiful thing. Especially if somebody has health issues and their life expectancy isn't as long, why not retire early, now that you can get coverage, if you have the resources? And that's why it's good to work with a planner to make certain that you have that option.

Miller: And if you are doing that, pay careful attention to those premium subsidies that you mentioned earlier.

McClanahan: Right.

Miller: You may want to need to manage income to those subsidies, because the breaks are huge. And if you are retiring, probably you don't have that much ordinary income coming in, but you just need to watch that, because you go over the level, the top number, and suddenly the premium costs…

McClanahan: You lose a few thousand dollars. In fact, when I talk to financial planners around the country and accountants, they have a huge business opportunity here to help people with income planning. The thing you've also got to watch out for with early retirees is not having enough income, because if you go under 138% poverty level in states that offer Medicaid or under 100% in states that don't, you lose any tax credit.

Miller: That's a great point.

McClanahan: So, you've got to increase your income enough so you can qualify for a tax credit.

Miller: Yes. And then we've got half the states that didn't expand the Medicaid, so that's a problem.

McClanahan: Right.

Stipp: I want to turn and talk in the time we have left specifically about Medicare, which is obviously one of the big pillars of how you manage health care in retirement.

Let's zero in on some of the nuts and bolts of Medicare, so that folks who are entering retirement and maybe haven't done all the research on it yet can understand what their choices are going to be.

Let's first start with the basics: when does eligibility start, Mark, and what are the choices that you're going to be making?

Miller: The biggest headline on that is pay careful attention to your 65th birthday. Medicare has fairly steep penalties for enrolling late. In most cases, people need to enroll in a seven-month window before and after their 65th birthday. If you're already on Social Security that happens automatically, but if you haven't already enrolled in Social Security at 65, you need to take the proactive step of signing up.

The exceptions to that are, if you're still full-time employed and have group health insurance, you don't have to sign up for Medicare, but you want to make sure to carefully document that. Maybe even send a letter to Medicare saying, this is what I'm doing, so there's a record on that, because then later on, you don't want the risk of them misunderstanding and saying, oh, you signed up three years late and, therefore, the penalties.

Stipp: In that case, is there the option to choose between your employers' health care plan and Medicare?

Miller: The way it works is, if you work for a company with more than 20 employees, then your group health insurance remains primary. If you work for a small business, less than 20, then you go on Medicare. So there's really some complexity there that needs to be managed, because the penalties, I believe are 10% a year, for every year that you're late for life, so that adds up. So that's the big one. Pay careful attention to the enrollment schedules.

Stipp: And when you enroll, what are the choices that you're going to be making.

Miller: Really it boils down to two things. Do you want traditional fee-for-service Medicare or do you want Managed Care, which is called Medicare Advantage, and there are pluses and minuses to each.

Stipp: All right. Let's dig into some of those. What would be the swing factors and why you might choose one or the other?

McClanahan: To me, the most important thing is ask your doctor. If you have a doctor that you like, ask them what is their favorite insurance, and if they take a Medicare Advantage plan that's less expensive for you, then you could go with Medicare Advantage. If they don't, then … make certain you get a Medigap policy that they like.

Miller: And maybe just to clarify the detail of the difference between these two approaches just for a second, so everybody is on the same page.

Fee-for-service Medicare means you're enrolled in traditional Part A, which is hospitalization. You sign up for Part B, which is doctor visits for the most part. And you probably get a Part D prescription drug plan, maybe you add a Medigap plan, you probably do. So you have these different components, but it means you can see any doctor, go to any hospital that accepts Medicare, which is 99%, There are very few that don't. So that's that option.

Medicare Advantage is basically an HMO. So you're signing up for a network of physicians and hospitals. Your drug coverage is probably baked in. So those are really, at a slightly more detailed level, what these two choices are.

Stipp: So essentially fewer choice, then, if you take the Medicare Advantage?

Miller: Yes.

Stipp: Does that mean that generally the premiums are cheaper? You won't be spending as much?

Miller: One thing, a lot of Medicare Advantage plans have no additional premium for drug costs, so that's a big plus. Yes, you can save some money under certain circumstances in Medicare Advantage, but there are a couple of downsides: One is if you're a snowbird, and your network is in Chicago and you spend four months of the year in Florida, which sounds really good to me right now, then where do you get your care when you're in Florida?

I've also had some experts voicing concerns to me about [Medicare Advantage] MA plans in so far as nursing home care goes--that a lot of nursing homes will tell you to get out of MA as soon as you get here, because the MA plans will give us a lot of problems with reimbursement.

So the typical HMO problems can crop up in Medicare Advantage, but a lot of people like them, and the enrollment is growing. It's about a third, a little less than a third, of all Medicare beneficiaries now are in Medicare Advantage plans. So people are voting for them with their wallets.

Stipp: And what have the trends been as far as pricing and the fees that you pay? Are we seeing any relief from some of the health-care inflation that we'd seen?

Miller: Medicare costs have been really moderate. They've been flat for the last couple or three years, so that's a remarkable thing. We talked earlier about some of the underlying trends. Prescription drug costs have generally moderated. We haven't seen any huge new blockbuster brand-name drugs come on the market lately that are used by a mass number of people. The younger population of Medicare is another factor.

I think most experts say that the jury is still out as to whether this is a long-term moderation or not. But it's been really terrific for the last couple of years. The Part B premium didn't change at all this year from last, where it had been rising 5%-6%.

McClanahan: And I think some of the policies that are within the Affordable Care Act will help moderate costs in the future, which we have to. We spend more in health care in this country than any other country. Our cost per person is $8,500. The average OECD country is $3,300. So it's ridiculous what we spend, and part of that's driven by fee-for-service, which policies through Medicare will gradually bring that down.

Stipp: And since you mentioned that, I think this is, fiscally speaking, one of the big problems that the country needs to deal with: how are we going to pay, especially as the population gets older, for all of this health care?

So, Mark, what do you think if you're someone who's approaching retirement, Medicare is obviously going to be a big part of your retirement and your health-care management. What are the options on the table, first of all, for the government to fund Medicare? Might I expect that I will have to pay more or that I will have less coverage? What might the changes be, given that it's going to be a big expense for the country?

Miller: There are sort of two policy schools of thought about how to address Medicare costs. The conservative argument is more choice and sort of more Affordable Care Act-like exchanges, for example, the premium support idea. It also involves a lot of cost shift, though, because it sets a defined contribution to your coverage and then you're responsible for the rest. So, there's a lot of cost-shifting ideas, if you will.

The more progressive side of the table argues for fundamental reform in the way we deliver health care in the country, moving away from incenting providers to just deliver as much service as they can and get paid on the meter as opposed to for outcomes.

You mentioned the idea earlier, Carolyn, before we came in, of how do we fund primary care? Are there more efficient ways to do that?

So, there's a range of ideas that people have for how to reform the health-care delivery system so that our costs start heading down.

McClanahan: In a nutshell, we need to move it away from the focus on quantity of care to quality of care, and that's happening.

Stipp: Mark, you've written for Morningstar.com about the importance of re-shopping your coverage. What are the details of that, when does it happen, and why do you need to make sure you do it?

Miller: And here we're talking about Part D prescription drug plans or Medicare Advantage plans, which is Part C. There's an enrollment period at the end of every year. The big driver there, I think, the big one is prescription drugs, because the plans change from year-to-year, the so-called formularies of what a given plan will cover, and under what terms, will change.

So, it's a good idea, I think, to take a look at it every year--if not every year, every couple of years at least--to see if the plan you selected is still a good one for you. And the costs are all over the place. You have some really low-cost plans that might be good for you. But it really depends on what your drugs are. And the other is delivery system. Increasingly, the Part D plans are set up for efficient delivery either through one of the major drugstore retail chains or via the mail. So, you need to look at how is this going to arrive to me, and is it a way that is good for me, and it'll affect cost.

Stipp: And the Medigap policies that we mentioned before, when does those come into play, how would you shop for them? What do they cover?

McClanahan: Well, they cover what Medicare A and B doesn't cover. You can have unlimited out-of-pocket expenses with just having Medicare A and B. So, I personally think everybody should have a Medigap plan.

Miller: If you're in traditional Medicare, rather than Medicare Advantage.

McClanahan: Right.

Stipp: You wouldn't be doing Medigap if you were in Medicare Advantage?

McClanahan: No.

Miller: You can't. It's only for traditional fee for service.

McClanahan: So, if you go the traditional route for Medicare, it's so important to have a Medigap plan that helps some of the copays, the out-of-pocket costs. It provides more flexibility. Medicare alone does not pay for care overseas. So if you plan on traveling, it's good to have a Medigap plan that covers international health care, or buying a travel policy that will cover you when you're out.

Stipp: What are some of the trade-offs that you would be thinking about as you're doing that Medigap shopping? I assume there are different levels of out-of-pocket or deductibles?

McClanahan: Those are important. And again, I always say to people, ask your doctor what they like best, because you want to make certain you're on a plan that your doctor and that the hospitals you like to go to are in good stead with.

Miller: A couple of things about Medigap I wanted to mention. One is, if you're going to sign up for it, it's really good to sign it up for it when you enroll in Medicare at age 65, because there's what's called protected enrollment. The insurers have to offer you a coverage--you can't be turned away--and they have to offer you best-price coverage.

The plans are tightly regulated nationally. There's a series of plans that run--they're lettered A through M--and they're uniform nationally. Prices can vary regionally. So you can shop these different plan levels and decide what's right for you.

Stipp: And what are some of the things, again, that people need to remember that Medicare does not cover; the expenses that would be out-of-pocket costs. What kinds of costs are we talking about? Our Morningstar readers have mentioned dental as one of them.

McClanahan: Right. No dental.

Stipp: So, what are the things you need to keep in mind as you're moving into retirement, and you think Medicare is going to have me covered there, but it really doesn't?

McClanahan: Well, we can't say this enough: it does not cover long-term care except for the first 100 days and that's only after a true hospital admission. So, that's the big one. Of course, it does not cover dental care. It does not cover international care if you travel out of the states.

Miller: Alternative medicine, a chiropractor not covered. Cosmetic surgery.

McClanahan: Well, nobody covers that.

Miller: It doesn't cover having a caregiver in the house, like a housekeeper, personal care aid. But the out-of-pocket expenses on Part A--there's a deductible that, if you blow past that, you can look at some big dollars. So, probably the biggest protection of a Medigap policy is giving you additional hospitalization coverage.

Stipp: I just wanted to touch on this before we wrap up. From the planning perspective, we the trends in health-care costs. There seems to be some improvement now, but we've obviously seen way above general inflation on health care for a long time. How might that affect the way that you would think about planning if you're younger person? This is going to be a bigger proportion, right, of your out-of-pocket spend when you're in retirement, and if it has higher inflation, I don't like that combination very much.

McClanahan: Well, if you're a younger person, we have no idea what it's going to look like 20 years from now. So, to me, you should just be saving for the future for the day you can't work, quit worrying so much about health-care expenses in retirement, and make certain that you just have an overall plan for everything. And as you're getting closer to that time, when you're hitting your 50s and now it's a 10-year timeframe, then you need to start worrying more. People who are under 50, is Social Security going to be there for them? Most likely. And we have a lot of people under 50 who like to plan for it not being there.

So, I think you've got to look at your timeframe on when you need to start worrying about this.

Stipp: And there are also trade-offs for that, too. If I decide that I don't want to plan for any Social Security, that's going to have an impact on what I need to save today.

McClanahan: Right. That's exactly right.

Miller: It'll be a blowhole in a plan. The federal government is assuming long-range 5% health-care inflation right now. That's what they are working with. We'll see.

Stipp: Well, we've had a great conversation.

McClanahan: It's been fun. Thank you.

Stipp: There's obviously a lot to cover on health care. Thank you so much for joining me and for your insights on this really important big question mark for investors. I think we have some good anchors at least for investors to take a look at as they're trying to plan for this, some good frames of reference.

Dr. McClanahan, thank you so much.

McClanahan: Oh, my pleasure.

Stipp: Mark Miller, always great to get your insights on this.

Miller: Thanks for inviting me.

McClanahan: Thank you.

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