One of the most important factors you need to consider when putting together a retirement plan is potential long term care expenses. For those not familiar, long term care refers to expenses related to “Activities of Daily Living,” such as eating and bathing, that many eventually need help with as they age. In general, Medicare (the health insurance program for seniors) does not cover these expenses, so it is critical that you think through where the funds would come from. Care can be provided either in your home or in an assisted living or nursing home facility. There are three options: 1) Purchase long term care insurance 2) Set aside funds earmarked to cover these potential expenses 3) Don’t do anything knowing that you may need to spend down all your assets and move to Medicaid if significant long term care expenses are incurred. (Medicaid is the program run by individual states that funds medical expenses for the poor including long term care expenses for seniors with no assets).
First I will share some statistics related to long term care and then discuss pros and cons of the three approaches. In the US, about 70% of the population will eventually need some kind of assistance. For approximately 30% of the population, the care they receive is entirely “unpaid” (from a spouse, child, neighbor, etc.). About 40% of the population pays for some kind of care, and for half of that group the care is short term (i.e., less than one year). It is 20% of the population that needs care for an extended period, and for that group the average time care is needed is three years. It is to protect against this possibility that you need to plan for long term care. The cost of care can vary widely depending on location and type of care needed. Assisted Living generally ranges from $50,000 to $70,000 per year, and skilled nursing or higher need care such as Alzheimer’s can be $120,000 or even more per year. Using an average of $80,000 per year for three years suggests a cost of $240,000. With inflation that cost will rise to $500,000 in thirty years. When I work with my clients we usually plan for $450,000-$500,000 of potential expenses (in future dollars) for each client, knowing that individually there is a 20% probability of their incurring significant expenses.
For some people, option 3 (spending down assets and moving to Medicaid) is the only realistic choice. If your resources are limited, purchasing insurance will not make sense, nor will setting aside such a large sum. But know there are serious implications. You will need to spend down all of your assets before Medicaid kicks in. You will typically be able to keep your home, but after your death the state will generally seek reimbursement from any proceeds of the home sale, so there will generally be nothing to pass on to heirs. Beds in Medicaid facilities are also very limited, and there is much uncertainty in my opinion as to the long term sustainability of the Medicaid program given the enormous number of people that will be added to the program over time and the political resistance to funding that cost.
For those who can consider options 1 or 2, I think it is critical that you do plan and do not “wing it” and hope for the best. Let’s first discuss insurance. I wish I could say that insurance is the ideal solution for everyone who can afford it, but that is not the case. The reason is that there is a high frequency of need for the benefits long term care insurance provides and thus the insurance is relatively expensive compared to the benefit received. I’ll use an example. A long term care insurance premium might be $2,500 per year and provide $500,000 of potential benefit in thirty years. If that person were to invest the $2,500 per year and earn a 6% compounded return, they would have approximately $200,000 available in thirty years. The $300,000 difference is the leverage from the insurance. But there is only a 20% probability that substantial expenses will be incurred.
A key factor to consider is whether that $300,000 of additional cost would jeopardize the retirement plan. If it would, then I would generally recommend the insurance. If not, then other considerations come into play. For example, a couple can purchase a shared care policy in which both partners can tap into the same pool of funds, significantly increasing the probability that the funds will be used. Another strategy many of my clients opt for is to purchase insurance to cover only half of the potential need and to self-insure for the other half.
One factor is psychological. I’ll often ask clients: “Which would make you feel worse…paying insurance premiums for thirty years and then realizing at the end that you won’t need it, or not purchasing the insurance and then needing it and wishing you had.”
The best time to make the decision is when you are in your mid-50s. Prior to that the increase in premiums doesn’t make up for the extra years you are paying in. But by age 60 the premiums really start to escalate.
For clients who opt not to insure, what we do is assume in the retirement plan $450,000-$500,000 of spending per person in the future. One important consideration if you go that route (or even if you decide to insure for only half) is the tax implications of where you will draw the money from. The issue is that people with significant IRAs and 401Ks will have steadily increasing required minimum distributions after age 70 ½, and by the time they are in their late 80s or early 90s, the annual taxable withdrawals will be substantial. If you then pull another $160,000 out in a given year to pay for long term care expenses, the tax hit will be great, since you will likely be in a high tax bracket.
In that case, I work on with my clients on creating a pool of after tax funds that can be used to cover potential long term care expenses. The two vehicles that I use the most are Roth IRAs (funded via Roth conversions) and Whole life insurance. The advantage of a Roth is its flexibility. Five years after the conversion the money can be pulled out tax free at any time for any purpose. But it may not be possible to fund a Roth at a high enough level to create a sufficient pool of after tax funds.
That is where whole life comes in. The taxation on a whole life policy is the same as a Roth. You fund with after tax dollars and the amount then grows tax free. Unlike a Roth, however, you can continue to fund a whole life policy throughout your 70s and 80s using money from the IRA required minimum distribution. Returns on the death benefit for whole life policies can be in the 5% range at age 90, which is pretty good for a relatively low risk investment that also further diversifies a portfolio. The downside of whole life is that the only feasible way to access the cash value is via a loan using the cash value as collateral. Thus you would really only want to use those funds to either cover end-of-life long term care expenses or to pass them onto your heirs as part of your estate. Whole life gets a bad rap because agents will sell it, presenting it as a good vehicle for standard retirement expenses, which generally it is not.
The idea is that in either case (Roth or whole life), if the money is not used for long term care it will be passed onto heirs as part of the estate. My clients who opt to self-insure usually use a combination both the Roth and whole life.
As always, let me know of you have any questions about any of this.
Bill