A New Tool to Calculate Long-Term Care Needs

The projected costs represent amounts that would need to be set aside today to meet future care costs. I have used an estimated high-quality, long-term bond rate of 4% as a discount rate – similar to the way a corporate pension plan would discount future benefit costs.

The chart is more than a column of numbers. It represents a major leap forward in providing useful information for financial planning. Instead of a few sketchy statistics, we now have a customized projection based on particular client characteristics.

Here are a few observations on these numbers:

• The average cost significantly exceeds the median, indicating a distribution skewed toward higher costs, with substantial tail risk.
• The wide variability of outcomes indicates the high degree of uncertainty that LTC costs bring to retirement planning.
• Those who self-insure and wish to have a high probability of meeting LTC contingencies will need to set aside substantial funds.

The vast majority of financial plans are developed without explicit recognition of potential long-term care costs, and this example demonstrates that such projections leave out a major retirement risk. A plan for long-term care needs to be included in a full retirement plan.

Evaluating LTC insurance

A major financial decision for clients is whether to purchase LTC insurance. It's a decision fraught with uncertainty because, until now, the lack of good data on care costs has made it difficult to evaluate the benefits of purchasing insurance.

I'll use PDRP Plus to generate percentile outcomes with and without insurance. This particular example assumes that each member of the couple purchases a policy with the following provisions:

• Elimination period: 90 days (number of days after becoming eligible before benefits are paid)
• Maximum benefit period: 5 years
• Daily maximum benefit: $300
• Total benefit pool: $300 x 365 days x 5 years = $547,500 (available beyond 5 years if less than the full daily benefits used)
• Qualification for benefits: Inability to perform two or more activities of daily living (ADLs) or severe cognitive impairment
• Type of care covered: Comprehensive (home care and facilities care)
• Inflation rider: 5% compound (initial $300 daily benefit available increases at a compound annual rate of 5%)

The policies also include shared benefits – if one member of the couple exceeds his or her benefit limits, he or she can use available benefits from the other's policy. The price for these policies reflects the insurer’s assumption that on average, couples will rely more heavily on unpaid spousal care than will single individuals.

The estimated annual premium for this insurance package is just over $12,000, based on rates from Genworth, the leading LTC insurer. This is considerably more than typical LTC policies, for which the average premium per individual is about $2,500, as reported by the consulting firm Milliman in the 2013 LTC Insurance survey published by Broker World. However, the $12,000 is for a couple, and these policies contain significantly richer benefit provisions than the average policy (such as a $300 daily benefit versus an industry average $160). Also, the assumed issue age of the insured is 65, compared to the industry average of 56. The higher age further increases premiums.

The chart below shows projected outcomes.

The left column shows the percentile distribution of LTC costs, as in the first chart, and the second column shows the costs with insurance — the sum of insurance premiums and out-of-pocket LTC costs. The remaining columns split out the insurance premiums and benefits paid by insurance.

On a present value basis, the average cost with insurance of $206,060 exceeds the average cost without of $184,249. This would be expected, since the insurer needs to pay for claims and expenses and also earn a margin for risk and profit. The first two columns break even at the 75th percentile, and insurance does better at higher percentiles. Insurance mitigates, but does not eliminate, the increase in costs in the higher percentiles. Additional out-of-pocket costs arise because some conditions that require care may not be severe enough to qualify for claim payments and because the policy used in the example has coverage limits. For example, in going from the 95th to 99th percentile, projected LTC costs increase by $507,819 ($707,866 to $1,215,685), while the estimated benefits paid increase by $223,533 ($637,364 to $860,897).

This example provides an analysis using one particular LTC insurance policy and a single choice of features. In working with actual clients, an advisor would be able to show projected outcomes using a variety of policies and policy features.

Insurance considerations

Analyzing LTC insurance is more complicated than simply establishing an elimination period (akin to a deductible) and then buying enough insurance to cover remaining costs. It is possible to purchase lifetime benefit periods, but only a few insurers offer such coverage. It is expensive, because insurers build in extra charges for expected adverse selection (those clients in poorer health are more likely to purchase insurance). It will likely work out better financially to purchase insurance for a fixed benefit period.

It might also seem like a reasonable strategy to purchase a policy with a very long elimination period, say two years, and only cover the tail risk of the long-duration care needs. This could make sense for upscale clients who can afford to pay for short- and medium-duration care needs. But insurers have shied away from offering such policies, again because of concerns about adverse selection.

Insurers do offer an analog to high-deductible LTC insurance in the form of hybrid life/LTC policies, which I described in this December 2012 Advisor Perspectivesarticle. With these policies, life insurance benefits are paid out early if there is a qualifying LTC need, and additional LTC benefits only get paid out after most of the life insurance is used up. An advantage of such policies is that they eliminate the risk of not receiving any benefits, since monies get paid out either as death claims or LTC claims. A disadvantage is that purchase of these single-premium hybrid policies ties up funds in low-yielding insurance-company investments. The benefit structure used in the example would require an up-front investment of about $400,000, compared to paying $12,000 per year for LTC premiums and having remaining savings available for regular investing.

Considerations for advisors

Advisors can provide a valuable service for clients by helping them proactively develop a strategy for LTC and, in particular, helping with the decision of whether to buy insurance. We now have a much better way to evaluate LTC risk and the costs and benefits of purchasing insurance. This adds an important dimension to financial and retirement planning, which has mostly focused on the impact of investment performance and has not paid enough attention to LTC risk.

There are many issues for advisors in working with clients on LTC, including personal and family issues for clients and an LTC insurance industry that has been going through a lot of turmoil during the past few years. It's certainly a challenging area for advisors, but as the example in this article illustrates, LTC is a risk that advisors and clients cannot afford to ignore. Improved assessment tools will help advisors provide more value for clients.

Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.

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