There’s an old rule of thumb that suggests you’ll spend 20 percent to 30 percent less money after you retire. However, recent research shows that baby boomers are actively maintaining or even increasing their spending, especially early in retirement, when they’re healthy and have more leisure time. Some have called this phenomenon a “second, unsupervised childhood.” Eventually, as most people age, they slow down; spending typically declines once people get into their mid-70s. At that point, the expenses that your clients, their children and their financial advisors may worry most about are those related to an unexpected end-of-life health care event.
Research shows that 69 percent of individuals over age 65 will need some kind of long-term care (LTC) in their lifetime,1 so factoring in this possibility can be extremely important to retirement financial planning. After all, while some individuals are fortunate enough to live relatively healthy lives in their own homes, without requiring advanced care, others will have a health care event requiring significant resources that, in some cases, can exhaust their assets.
We’ve developed a framework for assessing the likelihood that a couple will benefit from LTC insurance. We’re using a solutions-based approach, meaning that our decision criteria are based on whether LTC insurance may significantly improve the probability of a couple’s meeting their financial objectives. Although there’s a lot of uncertainty on the future cost of insurance premiums and nursing home costs, we’re demonstrating a way to incorporate an estimate of costs into a comprehensive financial plan.
LTC is defined as medical or personal care services needed for an extended period of time. The three most common tests insurance companies use to determine if treatment is covered are whether: (1) a person has cognitive impairment, (2) the care is medically necessary, or (3) there’s a need for help in performing a specified number of activities of daily living (ADL). Examples of ADL are bathing, dressing and eating. Sometimes, policies also include what are called “instrumental activities of daily living,” such as cleaning, cooking and grocery shopping.
Many people expect Medicare to cover the costs of long-term health care. However, Medicare runs out after 100 days of nursing care at a facility, with patients typically left footing the rest of the bill. For those who wish to be in the comfort of their own home, Medicare won’t cover the cost of extended in-home services. State-run Medicaid is intended for individuals with low income or few assets. There are strict guidelines as to how much in assets an individual can own to qualify for Medicaid. The government will perform a 5-year look-back if someone tries to qualify for assistance by gifting all of his assets.
Several institutions have conducted studies on the cost of long-term health care. Genworth Financial’s 2013 Cost of Care Survey2 differentiates the type of cost by city. “A Significant Expense,” p. 49, gives examples of nursing home costs (which, generally, include room and board, personal care and 24-hour skilled medical care) for several U.S. cities.
When it comes to LTC, there are three main options:
1. Family: Your clients can rely on their children or spouses to take care of them. This is generally the cheapest option. The issues to consider: Will their children have to give up a job to provide care? Are your clients comfortable imposing on their children? Who will care for the surviving spouse?
2. Self-insurance: Your clients can pay for any expenses out of pocket when they occur. The issue here is whether a client has sufficient funds to cover these costs. The benefit of self-insurance is that if a client doesn’t need LTC, the money that would have been spent on premiums is available for his heirs. However, if a client does require LTC, this savings may be only a fraction of the costs that he’ll ultimately incur, resulting in a diminished legacy.
3. LTC insurance: This is the traditional pay-as-you-go policy (similar to medical insurance). Annual premiums are sent to the insurance company, and benefits are paid if the triggers are met. Each policy is different, and it’s important for the policyholder to read the fine print and understand what’s considered a trigger; what costs are eligible; and for how long they’ll be paid. Premiums are largely based on age and health at the time of purchase. Generally, as people get older, health issues surface, and they run the risk of rejection for insurance. Purchasing too young, however, could mean paying premiums for a longer period with a lower likelihood of needing the insurance. It’s important to note that premiums aren’t fixed and can be increased. If a client never uses the insurance, the good news is that he’s healthy. The bad news is he’s lost the premiums paid. The average annual premium for a 60-year-old single individual can run between $3,120 and $9,720.3
Using our solutions-based framework, let’s evaluate the probability that purchasing a LTC policy for a couple at age 60 will increase the likelihood of meeting lifetime spending objectives and leaving behind a desired inheritance.
In our LTC insurance scenario, we’ll suppose that an individual pays a starting premium of $5,909. If a couple gets a 20 percent discount, the starting premium would be $4,727 per person per year. In addition, let’s assume this premium cost increases 1 percent per year throughout the analysis, with an additional one-time increase of 20 percent after 10 years. There will be a lifetime maximum insurance benefit of $91,000 per year (in 2014 dollars) per person, increasing by 5 percent per year thereafter. By the time the individual is age 80, the maximum lifetime benefit will be equal to approximately $241,000 per year. These policies will cover benefits for up to three years. With a traditional LTC policy, there’s no buildup of cash value, so the policyholder would forgo all the premiums paid and the ability to add that money to his estate.
In the self-insurance scenario, a couple could choose not to pay the insurance premiums and instead self-insure by investing the “premium” dollars into their portfolios. In this scenario, the post-tax value of the “premium” dollar portfolio would grow to approximately $371,000 in the median case (based on $4,727 per person annual investment into a 60 percent stock and
40 percent bond portfolio for 20 years). If they don’t need LTC during their lifetimes, the self-insurance portfolio would be available for wealth transfer.
To analyze the trade-off, we’ll use conservative assumptions. Let’s say that the husband needs LTC at age 77 for three years and the wife at age 80 for five years. We’ll project that their expenses increase with inflation until LTC is needed for the wife, at which time their spending decreases by 30 percent. (It’s quite possible that their spending decrease will happen sooner.) We’ll also assume that their portfolio is invested 60 percent in stocks and 40 percent in bonds. To assess the probability that they’ll meet their objectives, we’ll evaluate 5,000 plausible future scenarios using a Monte Carlo simulation. This is a statistical technique that calculates a range of outcomes and probabilities based on both the clients’ future spending needs and potential market returns.
In addition, in each scenario, we’ll test a range of wealth levels to identify the profiles for which having LTC insurance has the most impact. We’ll consider the benefit to be more significant if adding LTC insurance results in a better than 50 percent likelihood of not running out of money and improves that likelihood by at least five percentage points.
In our research, we find that, to the extent your client will need LTC, there’s a wealth “sweet spot” at which LTC insurance significantly improves the probability of sustaining retirement spending. For the typical family of modest wealth (below the sweet spot), there’s a high risk of portfolio exhaustion should they become subject to an expensive end-of-life event, regardless of whether they have insurance. At the other end of the spectrum, families with substantial wealth (above the sweet spot) can self-insure. They’re likely to be secure financially and leave an inheritance regardless of insurance. It’s in the middle bands where LTC insurance becomes a potentially value-added proposition. In Los Angeles (an average-cost market), there’s an improvement in the odds for couples with between $1 million and $6 million in liquid net worth. In Manhattan (a high-cost market), the range for couples is $3 million to $12 million. (See “The Wealth Sweet Spot,” this page.)
Let’s continue with the fact pattern outlined above and evaluate the outcomes for a couple, aged 60, living in Manhattan, with a liquid net worth of $4 million and planned spending of $140,000 per year, increasing with inflation. They have two children and two grandchildren who live in Los Angeles, and they’re considering relocating there. For the sake of simplicity, let’s assume that their non-health care spending would be the same in either location. Using the nursing home costs and insurance premiums outlined above, let’s assess the probability that they can sustain their lifestyle with or without LTC insurance.
In “Probability of Sustaining Spending,” this page, you can see that, should they stay in Manhattan, your clients will have a 65 percent chance of sustaining their spending without LTC insurance. However, having insurance significantly increases their odds to about 80 percent. On the other hand, in Los Angeles, they have an 85 percent chance of success without insurance. The combination of moving to Los Angeles and getting insurance raises the odds of success substantially, from 65 percent to 95 percent.
There are additional variables that investors will want to assess in making the decision about whether LTC insurance might improve the probability of sustaining lifetime spending. These factors include:
• Age of the individuals. Starting younger can lower the premiums and ensure insurability. On the other hand, starting older, if the individual is still healthy, may reduce the overall cost of insurance.
• Number of individuals in the household for which LTC is a possibility.
• Family health and longevity history and how long the individual might have to stay at a LTC facility.
• Cost of LTC in the area where an individual resides.
• Expected living expenses during retirement and as a percentage of the portfolio.
• Anticipated future inflation, generally, and for LTC, in particular.
• Wealth transfer objectives.
This type of analysis can provide individuals with additional perspective to help make an informed decision as to the appropriateness of LTC insurance for their situations. Clearly, the analysis is only as good as its assumptions and should be customized to each circumstance. For families in the LTC sweet spot in terms of portfolio net worth, our research shows that with a fact pattern similar to our case study, having an LTC policy may increase the likelihood of a secure retirement.
—The authors gratefully acknowledge contributions to this research by Michelle Black at Capital Group Private Client Services in London and Petra Chien at Capital Group Private Client Services in Los Angeles.
—The views expressed herein are those of the authors and don’t necessarily reflect the views of everyone at Capital Group Private Client Services.
—Notes on Wealth Strategy Analyses: For the purposes of these illustrations, we assume the portfolio is invested 60 percent stocks and 40 percent bonds. Stocks are invested 90 percent in global equity and 10 percent emerging markets and bonds in intermediate duration municipal bonds. The calculation takes into account federal, state and local taxes, as well as the Medicare investment surtax based on the tax bracket created by the investment income. We’ve assumed that the full amount of state and local taxes paid is deductible on the federal return (for example, the Pease Limitation has been taken up by other deductions). We assume the couple has retired and is spending 3.5 percent of the initial value of their portfolio per year for living expenses until long-term care (LTC) is needed for the wife, at which time their spending decreases by 30 percent. All spending is increased for assumed inflation of 2.25 percent throughout the analysis. The scenario assumes the husband needs LTC at age 77 for three years and the wife (or single individual) at age 80 for five years. We assume single California and New York residents pay an initial premium of $5,909 annually. Premiums for married residents are initially $4,727 annually per spouse (reflecting a 20 percent discount from the single premium above.
Data for capital market assumptions doesn’t represent past performance and isn’t a promise of future results. The assumptions used in the calculations are as follows: the expected return is 7 percent for global equity, 10 percent for emerging markets equity and 2 percent for bonds. These assumptions shouldn’t be interpreted as the view of Capital Group Private Client Services. They’re provided for informational purposes only and aren’t intended to make any assurance or promise of actual returns. They reflect our assumptions of long-term asset-class returns and are based on the respective benchmark indexes (MSCI World and MSCI Emerging Markets for equities and Barclays 1-10 Year Municipal Index for municipal bonds), and therefore don’t include any outperformance gain or loss that may result from active portfolio management. All market forecasts are subject to a wide margin of error, including those modeled here. Note that the actual results will be affected by the management of the investments and any adjustments to the mix of asset classes.
1. Peter Kemper, Harriet L. Komisar and Lisa Alecxih, “Long-Term Care Over an Uncertain Future: What Can Current Retirees Expect?” Inquiry (Winter 2005/2006), www.allhealth.org/briefingmaterials/Long-TermCareOveranUncertainFuture-WhatCanCurrentRetireesExpect-461.pdf.
2. Genworth Financial Cost of Care Survey 2013, www.genworth.com/global-corporate/about-genworth/industry-expertise/cost-of-care.html. Note that we’re assuming that a high-net-worth couple will prefer a private room. There’s also the option of a semi-private room, which is cheaper.