Safety First Retirement Plans and Health Care Costs – Are these two items compatible?

Two major approaches for retiree financial planning are the creation of (1) Probability Based Retirement Plans and (2) Safety First Retirement Plans

Very briefly, what are these two approaches?

Probability Based Retirement Plans calculate (usually using Monte Carlo techniques) the probability that the client will meet his various financial goals, including the goal of not outliving his assets.  This technique takes into (or should take into) account all of the financial aspects of the retiree’s plan.  The goals can be examined together or prioritized and examined separately.

Safety First Retirement Plans involve segregating the goals of the retiree into needs and wants.   The plan first makes sure that the needs are met.  Assets are devoted to the satisfaction of the needs.  Often guaranteed annuity/insurance products are employed to meet these goals.  Inherent in these strategies is the assumption that the amount of assets to meet goals can be determined or at least estimated within a small range.  Once the needs are met, then the wants can be examined.  The wants could be or not be satisfied, depending on many factors, including the size of the client’s asset portfolio.

The trouble with safety first strategies is that the requirement that the amount of assets needed to meet future health costs be determined or  at least estimated within a small range is not met.  Health care costs can vary a great deal over the course of a retiree’s lifetime, from a small amount to well over a million dollars.  That makes it almost impossible to rationally allocate the amount of assets to that need (and health care costs are a need and not a want).

Is it possible to employ insurance or annuities to reduce the variability of costs associated with health care? 

The retiree can buy Medicare Part D or a Medicare Advantage Plan, as well as Medicare Supplement Part F.  In some cases, this would reduce some of the variability associated with some health care costs, but not fully.

However, it is rarely possible to reduce the variability of the costs associated with long-term care.  The only possible way I see is to purchase long-term care insurance with an unlimited benefit period and with a 5% inflation rider.  Unpaid help is not a reasonable approach for the most difficult and costly long-term care needed.

The troubles with this insurance approach are:

More than half of retirees are simply not insurable for long-term care insurance.

Unlimited benefit periods are rarely available now, partly because the insurance companies who have sold this have lost money on unlimited benefit policies.

The premiums are very high and not suitable for all but the very wealthy.  Also, there is the real risk that the insurance company may raise the premiums after purchase.

Certain long-term care events are not covered by most long-term care policies

In summary, safety first strategies run into problems, often insurmountable, because of the variable and potentially extremely high cost of long-term care.

Therefore, I strongly recommend retirement plans constructed using safety first strategies be tested using probability tests, due to health care costs! 

Only PDRP Plus has the capability to correctly probability test plans, since it is the only system to correctly incorporate health care costs into its Monte Carlo testing.

Is there an intuitive way to understand the effect of health care costs on safe withdrawal rates? a/k/a "not convinced that health care costs greatly affect safe withdrawal rates?!"

Think of this topic this way: Fidelity Investments publishes annually an amount of assets that has to be set aside from a portfolio to pay for future health care costs.  Although their calculation does not include long-term care costs, and is assumed to be for a couple with a fixed set of conditions (fixed life expectancy, no chronic conditions and others), it is a good number to use for this blog.  The asset amount has been above $200,000, but I’ll use exactly that number to make the example easy.

First, assume a couple aged 65 has a portfolio of $600,000.  $200,000 is earmarked for health care costs, leaving $400,000 for spending.  Assume the 4% rule is applicable to that amount.   4% of $400,000 is $16,000, which is the amount of spending allowed.  But $16,000 is 2.67% of $600,000.  So a safe withdrawal rate here is 2.67% and not 4%.

Now assume that couple has a portfolio of $1,200,000.  The amount left after $200,000 is set aside for health care costs is $1,000,000.  4% of $1,000,000 is $40,000.  So the safe withdrawal rate percentage of the portfolio is $40,000 divided by $1,200,000, or 3.33%.

This is very rough, but is a good example of how health care costs can affect safe withdrawal rates downward, and how the calculation is specific to the individual retiree (much more so than is illustrated here!).

What is wrong is using a single date of death assumption in your analysis of your retiree client's goals?

The main advantage of using a single age at death assumption is that it is makes the calculations much simpler and faster.

There are some serious drawbacks to the use of a single age at death assumption, however.

In general, there are many financial aspects of retirement that are not analyzed if the fact that the client can die at any age is ignored.  The client needs to have an analysis that is consistent with this fact of life.  There is no substitute for planning that recognizes the client’s life expectancy and the associated probabilities of living to various ages.

Different pitfalls arise depending on how the single age at death chosen compares to the true life expectancy (and the probabilities of living to various ages) of the client.  I’ll examine a few of these pitfalls (there are many more I’m not covering in this brief blog) in the different possible cases – (1) when the client’s true life expectancy is greater than the chosen age, (2) when the client’s true age is less than the chosen age, and (3) even when the client’s true life expectancy is equal to the chosen age.  Without loss of generality, I’ll use a current client age of 65 and a true life expectancy of 20 years (bringing the client’s age at death to 85):

 IF THE SINGLE CHOSEN AGE AT DEATH IS LOWER THEN THE TRUE LIFE EXPECTANCY OF THE CLIENT (AGE 80 IS USED):

The annual expense budget will be overstated.  The spending may be designed to last to age 80, but the client will live on average to age 85.  The client’s asset portfolio could become depleted, even though spending recommendations were followed.

Health care costs will be understated (assuming they are even addressed).  The issue of needing long-term care after age 80 will be ignored.  The client may very well live past age 80 and may incur high health care costs.  This could greatly increase the chance of financial ruin.

The analysis of whether immediate or deferred income annuities are helpful will be incorrect assuming the client will die at age 80 in all instances – the analysis would show that annuities would be harmful to the client when they may actually be helpful.

IF THE SINGLE CHOSEN AGE AT DEATH IS HIGHER THEN THE TRUE LIFE EXPECTANCY OF THE CLIENT (AGE 95 IS USED):

The annual expense budget will be understated.  This would cause an unnecessary cutback in the client’s lifestyle.  Sometimes an adviser will set a very high age “so that the client can sleep at night”.  But this gives the client wrong information.  

Health care costs will be overstated (assuming they are addressed, which of course they absolutely should be).  There will be an overstatement of the long-term care and other health care needs.

There will be too good a result shown for immediate and deferred income annuities.  They will be shown to pay out more in benefits than should be shown.

IF THE SINGLE CHOSEN AGE AT DEATH IS EQUAL TO THE TRUE LIFE EXPECTANCY OF THE CLIENT (AGE 85 IS USED):

Health care costs will probably (if the life expectancy is not extremely high) be understated (again, assuming they are addressed).  Health care costs are greatest at the high ages, and assuming the client dies just at the life expectancy will probably understate these costs greatly.  

The analysis of whether immediate or deferred income annuities are helpful will probably be incorrect, even though the correct life expectancy is used.  They will generally illustrate worse than they should, and it is unclear whether the analysis will correctly show if the annuity would be helpful or not.  The actual extent that they would be helpful or harmful will probably be incorrect, no matter whether the direction the analysis gives is correct.

In summary, these drawbacks are serious.  Clients are not getting the information they need to properly plan unless the probability of living to different ages, based on the life expectancy of the client, is incorporated into the planning!

Budgeting for a retiree, after solving for the safe withdrawal percentage incorporating health care costs- what is different?

Some retirees use a safe withdrawal rate to determine how much they can withdrawal from their portfolio each year.  This is done so that the retiree will not outlive his/her assets.  A budget for the retiree can be done in accordance with the safe withdrawal to give guidance to the client.

How does budgeting differ for a retiree when health care costs are separately calculated (as they are in PDRP Plus)?

Budgeting for retirees has traditionally involved projecting the expenses for the retiree for the upcoming period of time, usually one calendar year.  Typical expenses would include food (at home and at restaurants), utilities, car expenses, vacations, real estate taxes,gifts to charities and many other items. This budgeting generally includes health care costs.  Of course, that is a problem with budgets, since the healthcare costs can vary a lot (due to the uncertain risks of long-term care, hospital and doctor visits and drug costs), and the budget will not always predict the costs accurately.

BUT:

Because PDRP Plus includes health care costs separately, there is no need to budget for these unpredictable costs.  By living within the safe withdrawal rate computed by PDRP Plus, there is much more certainty that the goal of not outliving assets will be met than by budgeting some fixed amount of healthcare expenses and hoping for the best.

TO REALLY BE TECHNICAL:

The following expenses are “built in” to the safe withdrawal rate computed by PDRP Plus.  The retiree does not have to budget the following items:

Health care costs, other than dental and eye care

Federal and state income taxes

Federal estate tax

State estate and/or inheritance tax

This simplifies the budgeting process and reduces guesswork!

A comprehensive approach to analyzing your client's long-term care costs - Part Three

If you haven't read the first two parts of this blog, please do so before reading this final installment.


How do you know if you have properly prepared your client for the contingency of future long-term care costs? 

The best way to answer this is to answer the more general, more important question:  Is your client satisfied with the chances that your retirement goals will be reached (including the all-important goal of not outliving your assets), taking into account his/her range of future costs of long-term care? 

To answer this question, it is necessary to combine the desired goals, with the range of costs of long-term care and with the following strategies and balance sheet items:

1. Spending strategy.  What is your client's planned spending for living expenses, vacations, new cars, etc.?  Include medical costs and prescription drug costs (Jack P Paul Actuary, LLC can assist in planning for these two items).
2. Investment strategy.  This includes, but isn't limited to the composition of the client's initial investment portfolio, the anticipated reinvestment/disinvestment of cash flows, the mix of qualified vs. non-qualified assets, and rebalancing strategies.
3. Insurance strategies.  Should there be a purchase of long-term care insurance?  Perhaps an annuity with a long-term care rider?  What about prescription drug plans?  Longevity annuities?  (Again, Jack P Paul Actuary, LLC can assist in determining appropriate insurance strategies).
4. Long-term care Plan of care strategy.  This was discussed in Part One of this blog.
5. Tax strategies.  When to take certain income, deductions, capital gains/losses are active decisions that should be incorporated into this analysis.  Other tax strategies are embedded in the investment strategy, such as when to use qualified vs. non-qualified assets and the tax implications of using one mutual fund vs another.
6. Existing and Future income.  Including earned income and income not included in the investment strategy.  This often includes decisions as to when to start taking Social Security Income.  (Again, Jack P Paul Actuary, LLC can assist in determining the optimum time/age to receive social security income).
7. Existing and future liabilities.  This includes credit card balances, house and car payments and other items.  Care should be taken to determine the time when balances become due and payable (for example, upon a death).
8. Estate and legacy strategies.  This includes leaving money in the will as a goal of the client.

These are all incorporated into programs which perform Monte Carlo testing on the investment rates, mortality and morbidity rates (morbidity includes health care, long-term care, and prescription drug rates of use) and which incorporate the above eight items, to calculate the probabilities that the client will meet his/her goals. 

After these probabilities are computed, iterations are performed and the programs rerun, to determine a set of realistic, achievable strategies that arrive at an acceptably high probability of success of the client goals.  Most often, the most important strategy is the spending strategy, in terms of affecting the probabilities and in terms of the client's future lifestyle.  There is often a tradeoff between the amount of money that the client would like to have available to live on, and the chances of meeting his/her goals. 

In summary, future long-term care costs are an important consideration for those nearing or at retirement.  The methodology presented in this three-part series allows these costs to be planned for in a comprehensive, analytical way, customized to the client.

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For a limited time, Jack P Paul Actuary, LLC will work with you to produce a comprehensive analysis of a client at 30% off the regular price.
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This article copyright by Jack P Paul Actuary, LLC 2012

A comprehensive approach to analyzing your client's long-term care costs - Part Two

If you haven't seen Part one of this three part series, please read that before you read this post.

Part Two - How insurance affects the range of long-term care costs:

The second major step in analyzing a client's future long-term care costs is the analysis of how insurance affects the range discussed in Part One of this blog.  Long-term care insurance affects the range of long-term costs in significant ways.  Premiums are payable, which increase the total cost, and eliminate any chance of having zero cost for long-term care for your client.  Of course, the insurance pays for some of the long-term care costs, up to the policy limits.  It is important to note that the policy assumed here is a tax-qualified one, which means that not all long-term costs will be covered by the insurance.  For example, if a policyholder can't perform only one of the Activities of Daily Living, the policy would not pay for long-term care benefits. 

Here is a chart of how the long-term care range of costs displayed in Part One now looks with the purchase of a representative long-term care policy.  The policy has a $200 benefit amount per day maximum payable on a reimbursement basis, a 4 year pool of benefits, a 90 day elimination period and a 5% compound inflation rider.  For comparison purposes, the present value of costs are displayed both with and without the insurance policy:

The probability, on a present value basis,
that the long-term care costs will not
exceed the Specified Amount                      Specified Amount             Specified Amount
                                                                      without insurance              with insurance
10%                                                                $0                                       $24,000
20%                                                                $0                                       $35,000
30%                                                                $0                                       $42,000
40%                                                                $0                                       $47,000
45%                                                                $0                                       $49,000
50%                                                                $0                                       $52,000
55%                                                                $1,000                                $54,000
60%                                                                $4,000                                $56,000
65%                                                                $10,000                              $59,000
70%                                                                $19,000                              $61,000
75%                                                                $34,000                              $65,000
80%                                                                $55,000                              $73,000
85%                                                                $89,000                              $84,000
90%                                                                $141,000                            $103,000
95%                                                                $276,000                            $144,000
98%                                                                $486,000                            $274,000
99.5%                                                             $1,288,000                         $1,053,000

The addition of insurance changes the probability distribution significantly.  Due to the premiums payable, there will always be long-term care costs that need to be paid.  On the other hand, the costs that will be paid under the higher cost scenarios are considerably less with insurance than without.  For example, the amount of assets that must be set aside to ensure that, with 98% probability, that the client's long-term care costs will be covered is $486,000 if the client does not purchase the long-term care policy described above.  That $486,000 reduces to $274,000 if the client purchases the policy, a 44% reduction!

The details behind the chart show that 84.8% of the time, the amount needed to be set aside to cover the client's long-term care costs (in other words, the present value of the client's future long-term care costs) will be less without the insurance.  Also, the "loss ratio" for this policy is computed to be 61%.  That means that, on a present value basis, for every dollar the client gives to the insurance company, 61 cents will be paid out in benefits.  This assumes the client always keeps the policy in force until benefits are exhausted and does not let it lapse.  Some would judge this to be a lot of money - 39 cents on the dollar - to spend for the protection.  The next paragraph is my argument for why long-term care insurance gives effective protection.

One of the strongest arguments for the purchase of long-term care insurance is as follows:  The client can choose to purchase or not purchase insurance.  If the client purchases insurance, there is an 84.8% chance that he/she will pay more than if he/she hadn't purchased it, and a 15.2% chance that he/she will pay less.  However, the amount that he/she will overpay if insurance isn't purchased could be more than $232,000 on a present value basis.  The amount that he/she will overpay if the insurance is purchased is considerably less - up to only $70,000 on a present value basis.  This is what insurance should do - protect against large losses.  Long-term care insurance does this effectively in many cases. 

This information is derived from performing stochastic testing on long-term care liabilities and associated insurance.  Stochastic testing can be used to analyze a wide range of policies and features from different carriers.  Differing elimination and benefit periods, maximum benefit amounts, inflation riders and many other policy features can be examined.   Stochastic testing provides information to the client that is not available using any other method.  Similar testing can be done for annuities with a long-term care rider.  The range of costs vary significantly by issue age, mortality and morbidity profiles and plans of care and other considerations.  When performing stochastic testing it is best to use customized information for the case under consideration.

By using stochastic testing, a client's range of long-term care costs both with and without various insurance alternatives can be examined.  The major question remains to complete the comprehensive analysis:  How do you know if you have properly prepared for the contingency of future long-term care costs?  The answer is in part three of this series, which is the next blog. 


This article copyright by Jack P Paul, Actuary, LLC 2012

A comprehensive approach to analyzing your client's long-term care costs

Here is the first of a three-part series.  Here I explain a comprehensive approach to analyzing and providing an effective way to plan for your client's possible future long-term care costs.  This approach will allow you and your client to see the true risk of possible future long-term care costs, to see how the risk can affect your client's total financial picture, and how to best address the risk, through spending and insurance strategies.  Note that the client could be either a single person or a couple.

PART ONE: THE RANGE OF POSSIBLE FUTURE LONG-TERM CARE COSTS

The first major step is the analysis of how much your client will spend on long-term care costs.  This is not answerable as a fixed number.  The best that can be done is a probability distribution of your client's future long-term care costs.  A probability distribution, as used here, is a chart that states the chances that the future long-term care costs will not exceed different amounts.  The costs could be either the present value of future costs, or the total dollar amount of future costs.

Here is an example of what the chart could look like.  This chart expresses the costs on a present value basis.  One way to think about this present value basis is to consider the numbers in the chart as the amount of assets that should be set aside to fund future long-term care costs.  It is important to note that this is just a sample chart for illustration purposes only - the numbers do not apply to any specific person, although this chart does suggest the general shape of the distribution.

The probability, on a present value basis,
that the long-term care costs will not exceed
 the Specified Amount                                                                      Specified Amount
50%                                                                                                    $0
55%                                                                                                    $1,000
60%                                                                                                    $4,000
65%                                                                                                    $10,000
70%                                                                                                    $19,000
75%                                                                                                    $34,000
80%                                                                                                    $55,000
85%                                                                                                    $89,000
90%                                                                                                    $141,000     
95%                                                                                                    $276,000
98%                                                                                                    $486,000
99.5%                                                                                                 $1,288,000

This chart shows that there is an over 50% chance that no long-term care costs will be incurred. It shows that there is an 80% chance that the costs will be $55,000 or less on a present value basis. It shows that, most of the time, the costs will be managable.  However, there is a chance that the costs will be very high. 

This chart allows the client to understand just what the potential risks are.  This chart is used as the cornerstone of the client's plan to manage long-term care costs.  Note that the chart is before any insurance or other solution is applied.   

Another chart, if the client would understand it better, is the range of total dollar costs that could be incurred.  That chart would display higher numbers on the right hand side of the chart, as there would be no discounting for interest.

In constructing this chart for your client, it is critical that it be based on the client's actual mortality and morbidity profiles.  The mortality measures the probability that the client will live to various ages (yes, the future long-term care costs are very dependent on how long the client may live).  The morbidity measures the health of the client with respect to needing future long-term care.  The better morbidity the client has, the lower the chance of needing long-term care, all other things being equal.  The morbidity and mortality profiles are determined by analyzing questionnaires that the client (with the help of the financial planner) fills out.  Note that these profiles are very useful to understand the client, over and above their use in a long-term care analysis.  The client probably would be happy to know this information. 

The chart is also dependent on the level of care desired.  Does the client have a nursing home in mind - perhaps one near where the residence is - that has a good reputation, or that the client knows someone else who was in that nursing home?  Would the client need a private room in a nursing home, or would be satisfied with a semi-private room?  Does the client wish to remain at the residence and use full time home help, no matter what the client's needs are?  A questionnaire can be filled out to address these issues; perhaps a visit, if desired, with a social worker or long-term care expert would help the client explore the level of care desired.  If desired, national, regional or local average costs of care can be used instead.

The chart is further dependent on the amount of unpaid help the client can receive.  Is the other member of the couple, if any, able to help provide care if needed?  For how many weeks/months/years?  Until the client is how old?  Are there children or other possible unpaid helpers?  It is very important to be realistic here - can the children really be relied on to help?

A technical note -  the chart that expresses future long-term costs on a present value basis is also dependent on the interest rate used to discount the costs.  This rate should be the average earnings rate, net of tax, that the client can expect on the client's portfolio.  The higher the rate the client can expect to earn, the lower the costs in the chart.

END OF PART ONE  - PLEASE PROCEED TO PART TWO


This article copyright by Jack P Paul, Actuary, LLC 2012