Long-term care expenses represent one of the largest, most uncertain risks to a retirement plan. Costs can range from $0 to several hundred thousand dollars depending on the type of care you need, and how long you need it.
It seems like everyone knows at least one person who had an extended stay in a long term care facility that significantly drained their financial resources. It’s not surprising that many retirees worry that long term care expenses will cause them to run out of money.
Three Funding Options: Insurance, Self-Funding, and Medicaid
There are three primary ways to address long term care expenses in a retirement plan. The first solution is to purchase long term care insurance. The second approach is to set money aside in an investment account that is “earmarked” for future long-term care expenses. I refer to this approach as “self-funding.” A third option is to forego insurance and self-funding with the plan to spend down your assets and rely on Medicaid if you need long-term care.
Like many other financial planning questions, the “right” approach to long-term care planning will depend on your financial situation and psychological makeup.
Low Income/Net Worth
If your income and net worth are low, you may not be able to afford long-term care insurance.
The cost of long-term care insurance has increased substantially since insurance companies first launched these policies. Now, it typically costs several thousand dollars per year for a married couple to purchase policies that will cover multiple years of nursing home expenses.
You probably won’t be willing or able to pay several thousand dollars per year for insurance if your annual retirement income is 30 to 40 thousand dollars. It's also unlikely that you'll be able to set aside enough money to self-fund future long-term care expenses.
If you fall into this category, your only option may be to exclude long term care expenses from your retirement plan. This approach will allow you to live life to the fullest while you’re healthy. If you end up needing a material amount of long term care, you’ll likely spend down your countable assets and rely on Medicaid to cover your expenses.
High Income/Net Worth
If your income and net worth are very high, you should be able to pay for long-term care on your own, and there's no need to purchase insurance.
For example, if you have five million dollars, a simple 4% withdrawal rate from your investment portfolio leads to $200,000 of annual income. That’s just about the national average cost of a 24/7 Home Health Aide (the most expensive type of long term care) according to Genworth’s Cost of Care calculator. High net worth people also commonly have maximal social security income or large pensions, which makes matters even better.
I’m not saying you should never buy long term care insurance if you have a high net worth. You just don’t need it. If purchasing insurance provides you with greater peace of mind, that’s a good enough reason to buy insurance, even if it’s not necessary.
Medium-High Income/Net Worth
If you fall somewhere in between those two ends of the spectrum, you should carefully consider what type of long-term care you want and how you'll pay for it.
Most people want to receive care in their home or in a high-quality long-term care facility. Additionally, they don't want to deplete their assets, so Medicaid is not an option.
If this sounds like you, there are two primary funding options for you to consider. The first option is to purchase a long term care insurance policy that covers the cost of the care you want. The other option is to “self-fund” long term care expenses by setting aside money and investing it.
There are pros and cons to each of these options. To help you decide which option is best for you, I’ve listed some of the key considerations below.
In my experience, the cost of purchasing insurance is usually comparable to the cost of self-funding. In other words, the annual premiums you pay for long-term care insurance are typically similar to the amount of money you would have to set aside each year to provide the same amount of long term care coverage.
For example, Genworth’s LTC Insurance Calculator, estimated the annual premiums for a 55 year old married couple to purchase long term care insurance for each spouse,
with $275/day benefit ($100,000/year), maximum benefit period of 3 years, no inflation increases, and a 90 day elimination period, to be $2,274.15 per spouse (total premiums of $4,548.30/year). Using my financial planning software, I estimate that the couple would have to set aside $5,000 per year to self-fund the same amount of long-term care expenses. I arrived at this number assuming the couple lives to age 90, needs long term care in the final 3 years of their lives, invests the money in a portfolio of 60% stocks and 40% bonds, pays an advisory fee of 1% and investment expenses of .3%, and targets a 90% probability of success.
It’s important to note that the costs of traditional long-term care insurance aren’t guaranteed. As I mentioned earlier, premiums have increased substantially for most policies over the past couple of decades. Many of my clients received notices that they must pay significantly higher premiums or cut their benefit amount. Much of this was due to the low interest rates and the insurance company actuaries overestimating policy “lapse rates.” Hopefully, premium increases will be less common going forward now that the insurance companies have adjusted their assumptions. However, you should be aware that it’s possible your premium will be increased or your coverage will be reduced in the future when you buy long-term care insurance.
Guaranteed vs. Non-Guaranteed Coverage Amount
Comparing insurance to self-funding is always a bit of an apples-to-oranges comparison because insurance involves a guaranteed amount of coverage and self-funding does not. A 90% probability of success with self-funding is not the same thing as the guaranteed benefit amount of the insurance policy.
That 90% probability of success number means there’s a 10% chance that setting aside $5,000/year will provide a lower benefit than the insurance policy and a 90% chance of providing a larger benefit than the insurance policy.
When you purchase long-term care insurance, you know the exact amount of lifetime benefits you are eligible to receive.
“Use It or Lose It”
Traditional long-term care insurance is a use-it-or-lose-it proposition. If you don’t use your long-term care insurance policy, then the money you paid in premiums will be “wasted.” That’s how many types of insurance operate, and there's nothing
necessarily wrong with that, but many people don’t like the possibility of paying tens of thousands of dollars in insurance premiums and receiving no benefit in return.
Insurance companies have created products to address this “use-it-or-lose-it” issue, but they’re costly. One option is to add a “return of premium” rider to traditional long term care insurance, but this will increase your premiums. Another popular option is “hybrid” long-term care insurance policies that combine whole life insurance or an annuity with long term care insurance. Hybrid policies are growing in popularity because your heirs can receive the cash value or death benefit of the policy if you don’t experience long term care during your life. However, these policies aren't quite as cost-effective as traditional insurance and typically pay low rates of interest.
If you choose to self-fund long-term care, your heirs will inherit the money that you set aside for your long-term care needs if you don’t end up needing long-term care.
Coverage Limitations, Elimination Periods, etc.
When you self-fund, the money is available when you need it in whatever amount you need until you deplete your assets. That's not the case with long-term care insurance policies. You must meet certain requirements before you can receive benefits.
Insurance policies typically won’t pay benefits until you’re unable to perform 2 out of 6 “Activities of Daily Living” (eating, bathing, dressing, toileting, transferring, and continence) or you have a cognitive impairment such as dementia or Alzheimer’s disease.
Additionally, long-term care policies will usually have an “elimination period” (most commonly 90 days) where you must cover expenses before the insurance company will start paying your benefits.
Most policies also have a daily benefit limit that caps the dollar amount the insurance company will reimburse for expenses incurred in a single day. Daily benefit limits create the possibility that you won’t be fully reimbursed for a particular day if the costs for that day exceed the daily benefit cap.
All of these features exist for practical reasons and help minimize the costs of long-term care insurance, but you should be aware that they exist.
Protecting Assets from Medicaid Spend Down Requirements
To qualify for Medicaid, you normally have to “spend down” your assets to very low levels. However, if you purchase a partnership-qualified policy with your state, most states will add the value of the long term care benefits you receive to your exempt asset amount when determining Medicaid eligibility.
Let’s say you purchase one of these policies, you end up needing long term care, and you receive $300,000 of benefits from the policy. If you normally would have had to spend your assets down to $2,000 to qualify for Medicaid, now you can maintain $302,000 and still qualify for Medicaid. This feature can allow you and your spouse to maintain more assets if you have an extended, expensive long term care need that isn’t fully covered by your insurance.
Not all long term care insurance policies qualify for this treatment. To be “partnership qualified,” the policy must meet specific criteria, such as providing inflation protection. If you’re unsure if the policy you own (or the one you’re considering) is a partnership qualified policy, ask the insurance company that issued the policy.
Dealing With Insurance Companies
When you go into a facility, you’ll have to file a claim to receive benefits. Also, many policies are “reimbursement” policies that require you to submit documentation of the expenses you incur in order to be reimbursed by the insurance company. I occasionally hear complaints from clients who have parents in a nursing home that it is a hassle dealing with the insurance companies and getting them to pay benefits.
If you self-fund, you (or whoever manages your finances) won’t have to deal with insurance companies because you’ll be paying the expenses out of your own pocket.
Most people let numbers dictate their financial decisions, but it’s also important to consider which option makes you feel better.
Many people have a psychological preference for purchasing a guaranteed amount of long term care coverage that is not dependent on investment returns.
Others hate the “use-it-or-lose-it” nature of insurance and aren’t bothered by the uncertainty of investment returns. They’re happy to put up with uncertainty if it
provides the potential for more coverage, and the ability to leave more money to heirs if they don’t need long-term care.
Ultimately, you want to make the choice that allows you to lead a happy, stress-free retirement.
The “right” approach to funding long-term care expenses is going to be different for everyone and will depend on your financial situation and psychological makeup. The most important thing is to build a plan for how you’ll handle potential long-term care expenses well in advance. No one likes to think about losing their physical or mental abilities, but the reality is that it happens to everyone at some point. Proper planning can help you live the final years of your life with as much independence and dignity as possible.