Within the last two weeks, I had a client inquire about a long term care (LTC) policy and a reporter call regarding pros and cons of LTC policies. I took it as a sign of what to discuss this week, and it’s also a good change of pace from the investment topics that I focused on over the past month.
First, let me describe the essence of an LTC policy. This is a policy written on an individual (the insured) to provide funding to the insured if/when the insured needs to recover in a nursing home setting due to chronic illnesses (alzheimer’s, dementia, arthritis, etc.). In order to begin receiving benefits, one of two things needs to occur:
- The individual cannot perform two of the six activities of daily living (i.e. cannot dress, eat, bathe, use toilet, maintain continence, transfer in/out of bed or chair) OR
- The individual has become severely cognitively impaired.
That is the core of the LTC policy. Now for the nuances of the policy.
Similar to auto insurance, homeowners insurance, and disability policies, there is a “deductible” in the form of a wait time from when you enter a nursing home and when you begin receiving benefits. It is called the “elimination period.” Typical policies have thirty- to ninety-day elimination periods. The shorter the elimination period, the more expensive the policy. Medicare covers the first twenty days and then there is a co-payment for the next eighty days. Therefore, a sixty to ninety day elimination period makes sense.
The benefit structure is now, for most policies, a pool of money scheme. This means that you pay for a monthly (or daily) benefit, say $4,700 a month, which will last a certain time frame, usually between two to four years. If it is four years, then your pool of money is $225,600. There are two ways to receive these benefits. Either you will be reimbursed up to your daily or monthly limit, or the insurance company will pay you on a per diem basis regardless of the cost of the nursing home. Policies are generally set up for reimbursement.
So far, I have used the term “nursing home.” However, you can also receive benefits for these other types of care:
- Assisted living care – For the frail elderly, but not at the high level needed in a nursing home.
- Hospice care– To help ease the physical and psychological pain associated with dying.
- Home Health Care – A nurse practitioner will come to the insured’s residence.
- Adult Day Care Centers – If insured lives with a caregiver who works, the insured can be transported to the facility while the caregiver works during the day.
Now let us delve deeper. Who needs an LTC policy and how much does it cost? Statistics always change, but should be relatively accurate. According to data from 2009, about 1% of people between the ages of 65 and 74 resided in a nursing home. The percentage jumped to 6% for those between 75 and 84. Then it quadrupled to 25% for those aged 85 and older. There is a 40% chance of a person aged 65 and older of entering a nursing home at some point. And for those that enter a nursing home, 50% of the people stay longer than 1 year. I interpret these stats to say that around 20% of people could end up needing an LTC policy.
What about cost?
I reviewed four policies for my client. The average cost was $2,928 per year for a pool of money totaling $228,800 of benefits. Her age is 40 and we asked for a standard rating. The policies have elimination periods of ninety days and a 3% inflation protection. Therefore, at age 75, if my client entered into a nursing home she would have $643,812 of benefits and she would have paid a total of $102,485 in premiums.
Now, is this good? Let’s try to quantify a few different scenarios.
The chart above shows our first scenario. Instead of buying an LTC policy at age 40, a client could put money aside and invest it in her brokerage account. (I will not jump into the tax advantages of investing in a Roth or Traditional IRA, or 401(k) in order to keep it simple). Let’s focus on the “Average” column. For the client to have access to the same amount of benefits (in today’s dollars – $228,800, inflation adjusted – $643,812), and to “invest” the same amount of money per year ($2,928), the client would need to earn 8.72% per year for 35 years. That type of return is not out of the realm of possibilities, but it is definitely an optimistic assumption. Strictly looking at the numbers, it would appear an LTC policy is the safer choice.
Now check out the chart below.
The scenario above shows that the client waits until age 65 to purchase an LTC policy. However, she does start saving at age 40 and targets those funds for medical expenses. The goal is to obtain the same amount of benefits ($643,812) as seen in the first scenario. Let us keep the rate of return (8.72%) equal to the first scenario. You can see that the LTC policy will provide a little less than half of the benefits while the investments in the brokerage account fill the gap. However, you should notice that the total cost and investment is about $8,000 higher than the first scenario. You could call this the “penalty” of waiting to purchase the LTC policy. The difference is even smaller when you shrink the $8,000 to today’s dollars ($2,950) and spread that over 35 years.
Now for a third scenario:
This last scenario does not utilize an LTC policy at all. Instead, you utilize another insurance product – whole life insurance – and team it with a brokerage account. The death benefit of the life insurance grows at an annual rate of 6.35%, while the investments in the brokerage account earn 7.5%. The end result is that less benefits will be available for nursing home expenses, and you will have invested more than the other two scenarios ($130,865).
When you “run the numbers” (something a past co-worker would always tell clients when they asked a question), it would appear that an LTC policy would be less costly and less risky than the other options.
Okay, let’s get one!
But wait. Hold on. If I knew with 100% certainty that my client would not only incur nursing care expenses, but knew the exact amount, then absolutely – an LTC policy would be the best route. However, 1. You do not know if a client will incur those expenses and 2. You do not how much those expenses will be.
I believe there are two major risks with an LTC policy.
The first is cost of the policy. Insurance companies are allowed to raise premiums on a class basis even if you are locked in a contract that said the premium will remain the same. This could be a very real scenario considering the age of the LTC product. It originated in the 80s, was modified throughout the 90s, and is still slowly gaining traction. How accurate are the insurance companies in projecting these future medical expenses? I am not sure, but if homeowner’s insurance is any predictor, then we are in trouble. I am the treasurer of my condo association and our insurance premium rose from $1,700 to $2,600….that is not a typo. It rose 53% in one year. No claims arose last year. No accidents. Nothing. Just a “run of the mill” increase.
The second major risk, which I briefly touch on, is the uncertainty of your client’s future expenses. You can only estimate what medical expenses will arise thirty five years from now for your client. You can use family history, sure, such as if there is history of chronic illness. However, how those illnesses are treated today could be vastly different thirty-five years from now.
Due to those two risks, I oftentimes find myself steering clients away from LTC. Insurance is supposed to offer certainty, but these two risks destroy that peace of mind. As mentioned before, only one out of five people aged 65 or higher stay in nursing homes for more than 1 year. The average annual cost is around $90,000. Therefore, even the individuals who do incur those expenses should have enough retirement assets to protect them. If they do not, their problem is not medical expenses. Unfortunately, it is that they did not properly plan for retirement in general.
Look at the opportunity cost of LTC. If a client does not incur significant nursing care expenses, they sacrificed around half a million dollars due to lost opportunity cost. I am even being fair and assuming a reasonable 7.5% return. Remember, most policies have an elimination period of three months and Medicare provides some benefits. Therefore, you may incur nursing care expenses and not even receive any benefits from the policy you purchased.
If a client is very risk averse and wants certainty, I would be more inclined to utilize whole life insurance and pair that with savings in a brokerage account. That way, whether it is that client or her beneficiaries, those assets will be used. (Side note, I like the alternate options that whole life brings to a client’s financial life aside from LTC. And for those wondering, I do not receive any commissions as I do not write any insurance policies.)
If a client had prior positive experience with nursing care, perhaps her parents or grandparents stayed in a nursing home, I would be hesitant to have the client purchase a policy at age 40. Rather, I recommend that the client wait until age 65 (taking on the insurability risk) and have the client put away money specifically for future medical expenses. This is assuming no medical history was present. This way, you are closer to the 75 age mark and can make a more informed decision.
If a client insisted that she wanted an LTC policy right now, I would limit the amount of benefits, which would lower the premium. I would use a rule of thumb on how much extra money she could save per month, perhaps $100. Something nominal. That would amount to an annual premium of $1,200 and we would purchase a policy for that amount.
These last two paragraphs are ways to “hedge” your bets with/against LTC. Point is, I would not dive head first into the LTC pool. Every client’s financial situation is different; therefore very little in financial planning is black and white. Keep an open mind.
As always, this if for informational and educational purposes. Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument. What has worked in the past may not work in the future. Past returns do not guarantee future results.