Self-Insuring Your Long-Term Care (and Other Non-Recurring Expenses)

This post is a follow-up to our post of April 16, 2022
regarding planning for non-recurring expenses in retirement, with
emphasis in this post on long-term care costs. We also build on the
example discussed in our previous post.Expenses in retirement are
not generally linear from year to year. That is why simple spending
rules of thumb like the 4% Rule (with or without guardrails), or even
more sophisticated Monte Carlo models that develop probabilities that a
household can spend $X per year in real dollars, frequently fail to
reflect real-world spending in retirement and are, therefore, likely to
miss the mark. Developing and maintaining a robust spending plan in
retirement is a classic actuarial problem involving the time-value of
money and life contingencies. This problem is easily solved utilizing
basic actuarial principles, including periodic comparisons of household
assets and spending liabilities.In our previous post,
we discussed the example couple of John and Mary (two 65-year-old
retirees) originally introduced by Justin Fitzpatrick of Kitces.com. In
his article, Mr. Fitzpatrick indicated that, based on their assets and
some undisclosed assumptions, there was a relatively high probability
that John and Mary could afford to spend about $117,600 per year in real
dollars with $39,600 coming from annual withdrawals from their
portfolio (almost 4% of their initial $1,000,000 portfolio). Using
the Actuarial Financial Planner for Retired Couples (AFP) and our
default assumptions (and an 80%/20% split of essential vs. discretionary
recurring spending), we determined that John and Mary’s Funded Status
(comparison of assets and spending liabilities) was 100.87%, or somewhat
less robust than the financial picture painted by Mr. Fitzpatrick. But,
as noted in our previous post, Mr. Fitzpatrick did not plan for any
future non-recurring expenses for this couple. Let’s see what would
happen to John and Mary’s Funded Status if they decided to plan for
future long-term care costs in addition to their annual recurring
spending. ExampleThe AFP has 6 buckets
for determining the present values of future non-recurring expenses. It
also has 5 “other income” buckets that can also be used to calculate
present values of future non-recurring expenses by entering negative
amounts. These 11 buckets can also be used to calculate the present
values of almost any other non-linear stream of future expenses or
sources of income.To estimate the present value of their future long-term care costs, John and Mary visit the Median Cost Data Tables
at the Genworth Cost of Care website and look up median costs for
assisted living and nursing home care for their current state of
residence, which we will assume is California. They find that for 2024,
the median annual cost for assisted living in California is $75,000 and
the median annual nursing home cost for a semi-private room is
$136,875. John and Mary decide to plan on 2 years of assisted
living and 1 year of nursing home care to occur at the end of Mary’s
lifetime planning period. The average cost for that 3-year period (in
today’s dollars) would be $95,625, but they expect that their recurring
expenses would be reduced by $30,000 (in today’s dollars) for this
three-year period. Thus, they plan on incurring 3 years of extra
expenses of $65,625, in today’s dollars, at the end of Mary’s life. They enter the following amounts into row 41 of the AFP:Annual AmountDeferral Period (yrs)Payout Period (yrs)Annual Rate of Increase% Essential (Liabilities)$150,1452833%100%The
assumed cost starting in year 29 (the $150,145 annual cost in future
dollars shown above) is determined by increasing the average current net
cost of $65,625 developed above with their estimate of annual increases
in long-term care costs of 3% per year for 28 years ($65,625 X 1.03
**28). The annual rate of increase of 3% entered in the spreadsheet
applies for the years once payments are assumed to commence. John and
Mary determine, for their planning purposes, that these long-term care
expenses are not expenses they can simply reduce or eliminate if they
choose to (i.e., not discretionary), so they classify them as “100%
Essential”. This choice affects the discount rate used in the present
value calculations.The AFP determines the present value of this
assumed stream of payments under the default assumptions to be $112,728
(as shown in the PV Calcs Tab). This amount is added to their
liabilities and their revised Funded Status drops from 100.87% to 96.75%
as a result of recognition of this future cost. John and Mary wonder if
there are other non-recurring expenses they might encounter over the
next 30 years that should also be built into their plan, such as:Purchase of new carsLuxury TravelSupport of aging parents or childrenUnexpected home repair or desired home improvementsThey
also wonder if they should use the AFP to model possible future
decreases in their Social Security benefits or the future sale of their
home that were not reflected in their financial advisors model.Static Monte Carlo and 4% Rule Approaches vs. The Dynamic Actuarial ApproachIn
some ways John and Mary prefer the simplicity of their financial
advisor’s proclamation that they have a high probability of being able
to spend $117,600 in real dollars for the rest of their lives. They can
simply increase their spending budget each year with inflation, and they
don’t have to deal with annual budget calculations and possible
adjustments in spending. John complains that the Actuarial Approach
requires periodically thinking about their future spending, re-entering
revised data every year into the Actuarial Financial Planner and
possibly make spending adjustments based on their annually recalculated
Funded Status.Mary reminds John that:It may not be reasonable to simply trust their financial advisor as he does guarantee his resultsTheir
advisor’s assumptions about the future are unlikely to be 100% accurate
and some adjustments will likely be required over the next 30 years to
keep their spending on trackTheir spending is not likely to be the same real dollar amount from year to year, andIt
is a good idea to periodically revisit their plan and discuss their
spending, and it will probably take no more than one hour at the
beginning of each year to recalculate their Funded Status and document
their annual planning valuation.Mary convinces John that
the Actuarial Approach is the more prudent approach for achieving their
goals in retirement and for keeping their spending on track.ConclusionGood
financial planning during retirement involves periodic (we recommend
annual) re-measurement of the household Funded Status and adjustments in
spending when necessary. The re-measurement does not have to involve
simulations but it should involve estimating future expenses, be they
recurring or non-recurring in nature. If your financial advisor’s plan
does not anticipate non-recurring expenses, like long-term care costs,
you should consider using the AFP annually to measure your Funded
Status.